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Econometrica Vol. 78 No. 1 2010

Large Risks, Limited Liability, and Dynamic Moral Hazard

Bruno Biais1,2; Thomas Mariotti1,2; Jean-Charles Rochet2; Stéphane Villeneuve3,2,4,5,6

1 Centre National de la Recherche Scientifique · 2 Toulouse School of Economics · 3 Thales (Australia) · 4 University College London · 5 Universidad Carlos III de Madrid · 6 Université Paris 1 Panthéon-Sorbonne

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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.

DOI
10.3982/ecta7261
Volume
78
Issue
1
Pages
73-118
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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