Moral Hazard, Investment, and Firm Dynamics

We present a dynamic general equilibrium model with heterogeneous …rms. Owners of the …rms 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 …rms’investment, manager compensation and dividend payout policies. Risk sharing requires that managers’equity shares decrease with …rm sizes. This in turn implies that it is harder to prevent private bene…t in larger …rms, where managers have lower equity stake under the optimal contract. Consequently, small …rms invest more, pay less dividends, and grow faster than large …rms. Despite the heterogeneity in …rms decision rules and the failure of Gibrat’s law, we show that the size distribution of …rms in our model resembles a power law distribution with a slope coe¢ cient about 1.06, as in the data. We would like to thank Ravi Bansal, Dean Corbae, Steven Durlauf, Kenichi Fukushima, Adriano Rampini, Vish Viswanathan, Noah Williams, Tao Zha and seminar participants at the Fuqua School of Business at Duke University, Federal Reserve Bank of Atlanta, University of Calgary, University of Minnesota, and University of WisconsinMadison for useful conversations on the topic. We also thank Song Ma for his excellent research assistance. All errors are our own.