Ability, Moral Hazard, Firm Size, and Diversification

Debra J. Aron

RAND Journal of Economics, 1988, vol. 19, issue 1, 72-87

Abstract: I develop a model of firm diversification into multiple product lines that is based on the agency problem between the firm's managers and owners. The agency relationship, together with a span-of-control managerial technology, determines an optimal firm size and degree of diversification that are increasing in the manager's ability and therefore positively correlated cross sectionally. I compare the benefits of merger with those achieved by using compensation contracts based on relative performance and show that, for a particular parameterization, the relative value of merger is a nonmonotonic function of the correlation between the productivity signals of the two firms.

Date: 1988
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