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Large risks, limited liability, and dynamic moral hazard

  • Bruno Biais


    (CRM Centre de Recherches en Management - 2 rue du Doyen Gabriel Marty - 31042 Toulouse Cedex 9 FR, Université des Sciences Sociales (Toulouse 1))

  • Thomas Mariotti

    (GREMAQ Groupe de recherche en économie mathématique et quantitative - manufacture des tabacs - bat. F 21 Allée de Brienne 31000 TOULOUSE FR, Institut National de la Recherche Agronomique)

  • Jean-Charles Rochet


    (Groupe de Recherche en Economie Mathématique et Quantitative, INRA)

  • Stéphane Villeneuve


    (CRM Centre de Recherches en Management - 2 rue du Doyen Gabriel Marty - 31042 Toulouse Cedex 9 FR, Université des Sciences Sociales (Toulouse 1))

We study a continuous-time principal-agent model in which a risk-neutral agent with limited liability must exert unobservable effort to reduce the likelihood of large but relatively infrequent losses. Firm size can be decreased at no cost or increased subject to adjustment costs. In the optimal contract, investment takes place only if a long enough period of time elapses with no losses occurring. Then, if good performance continues, the agent is paid. As soon as a loss occurs, payments to the agent are suspended, and so is investment if further losses occur. Accumulated bad performance leads to downsizing. We derive explicit formulae for the dynamics of firm size and its asymptotic growth rate, and we provide conditions under which firm size eventually goes to zero or grows without bounds.

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Paper provided by Institut National de la Recherche Agronomique, France in its series Working Papers with number 245707.

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Length: 73-118
Date of creation: 2010
Date of revision:
Publication status: Published in Econometrica
Handle: RePEc:inr:wpaper:245707
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