A Quantitative Model of Dynamic Moral Hazard

Abstract

Abstract We develop an equilibrium 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 and exploit them to quantify the severity of the moral hazard problem. Our estimation suggests that unobservable shocks are relatively modest and account for about 10$\%$ of the total variation of firm output. Nonetheless, moral-hazard-induced incentive pay is quantitatively significant and accounts for 50$\%$ of managerial compensation. Eliminating moral hazard would result in about a 1$\%$ increase in aggregate output.