The effect of agency problems on optimal operating leverage and social welfare

Abstract

In this paper, we examine a firm’s choice of operating leverage in a principal-agent setting and find that the degree of operating leverage is strictly lower when the manager’s actions are unobservable. Further, the production output is also lower when agency problems are present. The suboptimal operational decisions result in not only decreased shareholder value, but also lower consumer surplus and lower total social welfare. However, accounting information can help mitigate this problem. Specifically, the more precise the accounting information, the less the reduction in the players’ payoffs. The results of this paper may provide some insight on how risk affects a firm’s stakeholders differently, and what consequences it has in a broader economic sense.