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A Theory of Firm Decline

Author

Listed:
  • Gian Luca Clementi

    (New York University, USA and The Rimini Centre of Economic Analisys, Italy)

  • Thomas Cooley

    (New York University and NBER, USA)

  • Sonia Di Giannatale

    (Centro de Investigación y Docencia Económicas, México)

Abstract
We study the problem of an investor that buys an equity stake in an entrepreneurial venture, under the assumption that the former cannot monitor the latter’s operations. The dynamics implied by the optimal incentive scheme is rich and quite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision becomes costlier as inside equity grows. In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment. In the long run, the entrepreneur gains control of all cash–flow rights and the capital stock converges to a constant value.

Suggested Citation

  • Gian Luca Clementi & Thomas Cooley & Sonia Di Giannatale, 2008. "A Theory of Firm Decline," Working Paper series 33_08, Rimini Centre for Economic Analysis.
    • Handle: RePEc:rim:rimwps:33_08
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

    Citations

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    as


    Cited by:

    1. Clementi, Gian Luca & Cooley, Thomas F. & Wang, Cheng, 2006. "Stock grants as a commitment device," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2191-2216, November.
    2. Sonia Di Giannatale Menegalli & Itza T. Q. Curiel-Cabral, 2013. "Compromises and Incentives," Working Papers DTE 559, CIDE, División de Economía.
    3. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
    4. Espino, Emilio & Kozlowski, Julian & Sánchez, Juan M., 2018. "Investment and bilateral insurance," Journal of Economic Theory, Elsevier, vol. 176(C), pages 311-341.
    5. Wang, Cheng, 1997. "Incentives, CEO Compensation, and Shareholder Wealth in a Dynamic Agency Model," Journal of Economic Theory, Elsevier, vol. 76(1), pages 72-105, September.
    6. Maideu-Morera, Gerard, 2024. "Firm Size and Compensation Dynamics with Risk Aversion and Persistent Private Information," TSE Working Papers 24-1535, Toulouse School of Economics (TSE).
    7. Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers 1176, Society for Economic Dynamics.
    8. Chang-Koo Chi & Kyoung Jin Choi, 2017. "The impact of firm size on dynamic incentives and investment," RAND Journal of Economics, RAND Corporation, vol. 48(1), pages 147-177, March.
    9. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    10. Loderer, Claudio & Waelchli, Urs, 2010. "Firm age and performance," MPRA Paper 26450, University Library of Munich, Germany.
    11. Emilio Espino & Julian Kozlowski & Juan M. Sanchez, 2013. "Too big to cheat: Efficiency and Investment in Partnerships," Working Papers 2013-001, Federal Reserve Bank of St. Louis.
    12. Jesse Perla & Carolin Pflueger & Michal Szkup, 2020. "Doubling Down on Debt: Limited Liability as a Financial Friction," NBER Working Papers 27747, National Bureau of Economic Research, Inc.
    13. Josepa Miquel-Florensa, 2013. "Dynamic contractual incentives in the face of a Samaritans’s dilemma," Theory and Decision, Springer, vol. 74(1), pages 151-166, January.
    14. Tsyrennikov, Viktor, 2013. "Capital flows under moral hazard," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 92-108.
    15. Chong Lai & Rui Li & Yonghong Wu, 2020. "Optimal compensation and investment affected by firm size and time-varying external factors," Annals of Finance, Springer, vol. 16(3), pages 407-422, September.
    16. Hengjie Ai & Rui Li, 2012. "Moral hazard, investment, and firm dynamics," FRB Atlanta CQER Working Paper 2012-01, Federal Reserve Bank of Atlanta.

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    More about this item

    Keywords

    Principal–Agent; Moral Hazard; Hidden Action; Incentives; Firm Dynamics;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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