Malfeasance and the market: Essays in corporate cheating
This thesis deals with “order without law”—efficiency or honesty in economic transactions under incomplete contracting. The overall focus is on corporate governance, with implications for economic development and contract theory.
In our first chapter, we apply game theory to corporate scandals, in which firm insiders cheat their investors, sometimes with the aid of external auditors. We characterize equilibria for different ranges of “warning signal” accuracy and withdrawal costs, identifying conditions under which external intermediation could help. Firm-hired intermediaries like transparency, but only up to a certain extent, while firms dislike it., as do intermediaries hired by investor consortia. Intermediaries' incentives to collude decrease with long life—an indirect benefit of the relatively low level of competition in auditing markets. Frequent rotation of an intermediary's clients may have costs, not just benefits.
In our second chapter we allow for stochastic firm performance known only to insiders in a game of imperfect public information. We endogenize payoffs and the formation of firms. With a minimum size requirement on enterprise, moral hazard constrains the ability to raise outsider capital, yielding a floor on personal wealth required to enter entrepreneurship. Credible auditing could create efficiency gains, our work suggesting mandatory disclosure of audit fees. We discuss consequences for patterns of enterprise financing in different countries, moral-hazard induced “vicious circles”, and the effect of inequality on industrialization.
In our third chapter we extend the second chapter's results to look at the three-way relationship between board, management and investors. Transparency of managerial compensation contracts can “trap” even opportunistic firms in honesty. Renegotiation possibilities serve to pin down firm size and ensure survival of the industry. Firms with greater total wealth are better able to offer their managers “efficiency wages” of the Shapiro-Stiglitz variety.
In our final chapter, we derive the optimal relational contract for a case of bilateral moral hazard where an input supplier sells an input of non-verifiable quality to a final goods producer.
0505: Business costs
0511: Economic theory