Risky Investments with Limited Commitment

Over the last three decades we have observed a dramatic increase in the concentration of income at the very top of the distribution. This increase in income inequality has been especially steep in the managerial occupations in financial industries, where it has often been associated with greater risk-taking using more complex financial instruments. Parallel to this trend, organizational forms in the financial sector have been transformed; in particular, traditional forms of partnerships have been replaced by public companies with weaker forms of commitment between investors and managers. In this paper we propose one possible explanation linking both trends. We emphasize the increase in competition for human talents that followed domestic and international liberalization of financial markets and its interplay with different degrees of contract enforcement, representing different organizational forms. Because of the limited enforcement of contracts, the increase in competition raises the managerial incentives to undertake risky investment. Although this may have a positive effect on economic growth, the equilibrium outcome is not efficient and generates greater risk-taking and income inequality.