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Managerial Incentives and Capital Management

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  • Bengt Holmstrom
  • Joan Ricart i Costa

Abstract

The paper shows how career concerns rather than effort aversion can induce a natural incongruity in risk preferences between managers and superiors. A model, based on learning about managerial talent, is developed to study second-best contractual remedies. We show that the optimal wage contract is an option of the value of the manager's human capital for insurance reasons and that consequently rationing of capital is often required to counterbalance the manager's resulting incentive to overinvest. Rationing is strictly superior to price decentralization, offering one reason for the prevalence of centralized capital budgeting procedures.

Suggested Citation

  • Bengt Holmstrom & Joan Ricart i Costa, 1986. "Managerial Incentives and Capital Management," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 835-860.
    • Handle: RePEc:oup:qjecon:v:101:y:1986:i:4:p:835-860.
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    References listed on IDEAS

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    1. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January.
    2. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, vol. 63(2), pages 134-139, May.
    3. Milton Harris & Bengt Holmstrom, 1982. "A Theory of Wage Dynamics," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 49(3), pages 315-333.
    4. Bengt Holmstrom & Laurence Weiss, 1985. "Managerial Incentives, Investment and Aggregate Implications: Scale Effects," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 52(3), pages 403-425.
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