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Moral hazard, investment, and firm dynamics

  • Hengjie Ai
  • Rui Li

We present a dynamic general equilibrium model with heterogeneous firms. Owners of firms delegate investment decisions to managers, whose consumption and investment decisions are private information. We solve the optimal contracts and characterize the implied general equilibrium. Our calibrated model has implications on the cross-sectional distribution and time-series dynamics of firms' investment, managers' compensation, and dividend payout policies. Risk sharing requires that managers' equity shares decrease with firm sizes. That, in turn, implies it is harder to prevent private benefit in larger firms, where managers have a lower equity stake under the optimal contract. Consequently, small firms invest more, pay less dividends, and grow faster than large firms. Despite the heterogeneity in firms' decision rules and the failure of Gibrat's law, we show that the size distribution of firms in our model resembles a power law distribution with a slope coefficient about 1.06, as in the data.

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Paper provided by Federal Reserve Bank of Atlanta in its series CQER Working Paper with number 2012-01.

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Date of creation: 2012
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Handle: RePEc:fip:fedacq:2012-01
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  1. Xavier Gabaix, 2008. "Power Laws in Economics and Finance," NBER Working Papers 14299, National Bureau of Economic Research, Inc.
  2. Peter M. Demarzo & Michael J. Fishman & Zhiguo He & Neng Wang, 2012. "Dynamic Agency and the q Theory of Investment," Journal of Finance, American Finance Association, vol. 67(6), pages 2295-2340, December.
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  7. Noah Williams, 2007. "Persistent Private Information," 2007 Meeting Papers 158, Society for Economic Dynamics.
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  10. Gian Luca Clementi & Hugo Hopenhayn, 2002. "A Theory of Financing Constraints and Firm Dynamics," RCER Working Papers 492, University of Rochester - Center for Economic Research (RCER).
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  12. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 599-617, October.
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  14. Rogerson, William P, 1985. "Repeated Moral Hazard," Econometrica, Econometric Society, vol. 53(1), pages 69-76, January.
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  16. Brandon Julio & Vito Gala, 2011. "Convergence in Corporate Investments," 2011 Meeting Papers 911, Society for Economic Dynamics.
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