Do Firms Diversify Because Managers Shirk? A Reinterpretation of the Principal-Agent Model of Diversification

Do Firms Diversify Because Managers Shirk? A Reinterpretation of the Principal-Agent Model of... In the principal-agent model of firm structure proposed by Aron (1988), diversification is optimal because it reduces managerial risk exposure. Diversification has this effect because it improves the monitoring function of output-contingent compensation which exists to alleviate the managerial moral hazard problem facing the firm's owners. But what if managers never shirk or can be easily observed by firm owners so the moral hazard problem vanishes? Does the optimality of diversification vanish as well? This paper develops a self-selection variant of Aron's model to show that the answer to this question is no. A by-product of this exercise is that it suggests how one might craft a test of whether the principal-agent model of diversification is driven by the problem of managerial moral hazard or managerial self-selection. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Industrial Organization Springer Journals

Do Firms Diversify Because Managers Shirk? A Reinterpretation of the Principal-Agent Model of Diversification

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Publisher
Springer Journals
Copyright
Copyright © 1997 by Kluwer Academic Publishers
Subject
Economics; Industrial Organization; Microeconomics
ISSN
0889-938X
eISSN
1573-7160
D.O.I.
10.1023/A:1007773415419
Publisher site
See Article on Publisher Site

Abstract

In the principal-agent model of firm structure proposed by Aron (1988), diversification is optimal because it reduces managerial risk exposure. Diversification has this effect because it improves the monitoring function of output-contingent compensation which exists to alleviate the managerial moral hazard problem facing the firm's owners. But what if managers never shirk or can be easily observed by firm owners so the moral hazard problem vanishes? Does the optimality of diversification vanish as well? This paper develops a self-selection variant of Aron's model to show that the answer to this question is no. A by-product of this exercise is that it suggests how one might craft a test of whether the principal-agent model of diversification is driven by the problem of managerial moral hazard or managerial self-selection.

Journal

Review of Industrial OrganizationSpringer Journals

Published: Sep 29, 2004

References

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