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Moral Hazard, Investment, and Firm Dynamics

Hengjie Ai, School of Business at Duke University

9th Dec 2011  11:30 pm - 12:30 am Room 214/215, Economics and Business Building

We present a dynamic general equilibrium model with heterogeneous firms. Owners of the firms delegate investment decisions to managers, whose consumption and investment decisions are private information. We solve the optimal contracts and characterize the implied general equilibrium. Our calibrated model has implications on the cross-sectional distribution and time-series dynamics of firms' investment, manager compensation and dividend payout policies. Risk sharing requires that managers' equity shares decrease with firm sizes. This in turn implies that it is harder to prevent private benefit in larger firms, where managers have lower equity stake under the optimal contract. Consequently, small firms invest more, pay less dividends, and grow faster than large firms. Despite the heterogeneity in firms decision rules and the failure of Gibrat's law, we show that the size distribution of firms in our model resembles a power law distribution with a slope coefficient about 1.06, as in the data.