Risk, limited liability and firm scope

This paper provides a new explanation for the relationship between firm scope, agent's effort and corporate risk. I set up a moral hazard in teams model with multiple agents and departments under the assumption that both the principal and the agents are protected by limited liability. Each agent exerts effort to reduce the probability of loss of his department. The two-sided limited liability assumption creates an externality between agents, since the bad performance of an agent could reduce the firm’s expected profit, and decrease the expected payoff of a good performing agent within the same firm. This would lower the incentive for other agents to exert effort, which causes 'Contagious shirking'. I prove for the optimal contract and derive conditions for effort to increase or decrease with scope, and explain why ‘contagious effect’ could better answer this question than diversification when firm scope is large.