City Research Online

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. © 2010 The Econometric Society.

Publication Type:	Article
Additional Information:	The copyright to this article is held by the Econometric Society, http://www.econometricsociety.org/. It may be downloaded, printed and reproduced only for personal or classroom use. Absolutely no downloading or copying may be done for, or on behalf of, any for-profit commercial firm or for other commercial purpose without the explicit permission of the Econometric Society. For this purpose, contact the Editorial Office of the Econometric Society at econometrica@econometricsociety.org.
Publisher Keywords:	Martingale representation theorem, delay differential equation, free boundary problem, verification theorem, Markov process, law of large numbers.
Subjects:	H Social Sciences > HA Statistics H Social Sciences > HB Economic Theory H Social Sciences > HD Industries. Land use. Labor > HD61 Risk Management H Social Sciences > HG Finance
Departments:	Bayes Business School > Finance
SWORD Depositor:	Symplectic Administrator

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