A Mechanism Design Model of Firm Dynamics: The Case of Limited Commitment

61 Pages Posted: 1 Nov 2013

See all articles by Hengjie Ai

Hengjie Ai

University of Minnesota - Twin Cities - Carlson School of Management

Dana Kiku

University of Illinois at Urbana-Champaign

Rui Li

Purdue University - Department of Economics; University of Wisconsin - Madison

Date Written: July 18, 2013

Abstract

We present a general equilibrium-mechanism design model with two-sided limited commitment that accounts for the observed heterogeneity in firms' investment, payout and CEO-compensation policies. In the model, shareholders cannot commit to holding negative net present value projects, and managers cannot commit to compensation plans that yield life-time utility lower than their outside options. Firms operate identical constant return to scale technologies with i.i.d. productivity growth. Consistent with the data, the model endogenously generates a power law in firm size and a power law in CEO compensation. We also show that the model is able to quantitatively explain the observed negative relationship between firms' investment rates and size, the positive relationship between firms' size and their dividend and CEO payout, as well as variation of firms' investment and payout policies across both size and age.

Keywords: Mechanism Design, Limited Commitment, Firm Dynamics

JEL Classification: E13, G30

Suggested Citation

Ai, Hengjie and Kiku, Dana and Li, Rui, A Mechanism Design Model of Firm Dynamics: The Case of Limited Commitment (July 18, 2013). Available at SSRN: https://ssrn.com/abstract=2347821 or http://dx.doi.org/10.2139/ssrn.2347821

Hengjie Ai (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

Dana Kiku

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

Rui Li

Purdue University - Department of Economics ( email )

West Lafayette, IN 47907-1310
United States

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

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