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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 with limited liability must exert unobservable effort to reduce the likelihood of large but relatively 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 downsizing. 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.

Abstract

We study a continuous-time principal–agent model in which a risk-neutral agent with limited liability must exert unobservable effort to reduce the likelihood of large but relatively 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 downsizing. 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.

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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
Scopus Subject Areas:Social Sciences & Humanities > Economics and Econometrics
Uncontrolled Keywords:Principal–agent model, limited liability, continuous time, Poisson risk, downsizing, investment, firm size dynamics
Language:English
Date:2010
Deposited On:19 Mar 2013 08:16
Last Modified:19 Aug 2021 16:06
Publisher:Econometric Society
ISSN:0012-9682
OA Status:Green
Free access at:Publisher DOI. An embargo period may apply.
Publisher DOI:https://doi.org/10.3982/ECTA7261
Other Identification Number:merlin-id:7948

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