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A Mechanism Design Model of Firm Dynamics: The Case of Limited Commitment

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  • Rui Li

    (University of Massachusetts Boston)

  • Dana Kiku

    (University of Ilinois)

  • Hengjie Ai

    (University of Minnesota)

Abstract

We present a general equilibrium-mechanism design model with two-sided limited commitment that accounts for the observed heterogeneity in firms’ investment, payout and CEO-compensation policies. In the model, shareholders cannot commit to holding negative net present value projects, and managers cannot commit to compensation plans that yield life-time utility lower than their outside options. Firms operate identical constant return to scale technologies with i.i.d. productivity growth. Consistent with the data, the model endogenously generates a power law in firm size and a power law in CEO compensation. We also show that the model is able to quantitatively explain the observed negative relationship between firms' investment rates and size, the positive relationship between firms' size and their dividend and CEO payout, as well as variation of firms' investment and payout policies across both size and age.

Suggested Citation

  • Rui Li & Dana Kiku & Hengjie Ai, 2014. "A Mechanism Design Model of Firm Dynamics: The Case of Limited Commitment," 2014 Meeting Papers 855, Society for Economic Dynamics.
    • Handle: RePEc:red:sed014:855
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    1. Erzo G. J. Luttmer, 2014. "An Assignment Model of Knowledge Diffusion and Income Inequality," Working Papers 715, Federal Reserve Bank of Minneapolis.

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