The Incentive Costs of Internalizing Externalities *

We present a dynamic agency model in which changes in the structure of a firm affect its value due to altered incentives. There may be disadvantages in merging two firms even when such a merger allows the internalization of externalities between the two firms. Merging, by making unprofitable certain decisions, increases the cost of inducing managers to exert effort. ∗Mailath and Postlewaite gratefully acknowledge support from National Science Foundation Grant #SES 0095768. We wish to thank Franklin Allen, Oliver Hart, David Martimort, Steven Matthews, Kevin J. Murphy, Sönje Reiche, John Roberts, and Huanxing Yang for valuable discussions and comments. †[email protected] ‡[email protected] §[email protected]