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Large risks, limited liability, and dynamic moral hazard


Biais, Bruno; Mariotti, Thomas; Rochet, Jean-Charles; Villeneuve, Stéphane (2010). Large risks, limited liability, and dynamic moral hazard. Econometrica, 78(1):73-118.

Abstract

We study a continuous-time principal–agent model in which a risk-neutral agent withlimited liability must exert unobservable effort to reduce the likelihood of large but rel- atively 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 downsiz- ing. 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.KEYWORDS: Principal–agent model, limited liability, continuous time, Poisson risk, downsizing, investment, firm size dynamics.

Abstract

We study a continuous-time principal–agent model in which a risk-neutral agent withlimited liability must exert unobservable effort to reduce the likelihood of large but rel- atively 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 downsiz- ing. 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.KEYWORDS: Principal–agent model, limited liability, continuous time, Poisson risk, downsizing, investment, firm size dynamics.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:2010
Deposited On:19 Mar 2013 08:16
Last Modified:05 Apr 2016 16:28
Publisher:Wiley-Blackwell
ISSN:0012-9682
Additional Information:The copyright to this article is held by the Econometric Society, http://www.econometricsociety.org/. It may be downloaded, printed and reproduced only for personal or classroom use. Absolutely no downloading or copying may be done for, or on behalf of, any for-profit commercial firm or other commercial purpose without the explicit permission of the Econometric Society. For this purpose, contact Claire Sashi, General Manager, at sashi@econometricsociety.org.
Publisher DOI:https://doi.org/10.3982/ECTA7261
Other Identification Number:merlin-id:7948

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