A Quantitative Model of Dynamic Moral Hazard

40 Pages Posted: 27 Jun 2016 Last revised: 29 Jun 2020

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: October 5, 2016

Abstract

We develop a firm-dynamics model with moral hazard, which arises because some productivity shocks are privately observed by firm managers only. We characterize the optimal contract and its implications for firm size, growth, and managerial pay-performance sensitivity, which allow us to
quantify the severity of the moral hazard problem. Our estimation suggests that unobservable shocks are relatively modest and account for about 30% of the total variation of firm output. Nonetheless, moral-hazard induced incentive pay is quantitatively significant and accounts for 51% of managerial compensation. Eliminating moral hazard would result in about 3% increase in aggregate output.

Keywords: Structural Estimation, Dynamic Moral Hazard, CEO Compensation, General Equilibrium, Firm Dynamics

JEL Classification: G1, G3

Suggested Citation

Ai, Hengjie and Kiku, Dana and Li, Rui, A Quantitative Model of Dynamic Moral Hazard (October 5, 2016). Available at SSRN: https://ssrn.com/abstract=2801116 or http://dx.doi.org/10.2139/ssrn.2801116

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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