A Model of Optimal Corporate Bailouts - Faculty of Business and ...

which implies effort of e ∗ 1 ( w 1 ) = w 1 /c − R 2 /(8·c 2 ). Comparing this expression with the effort inSection 2.2.1 (where the incumbent is fired) shows the moral hazard that managerial retentionin a restart induces. If the manager knows that she, too, will receive a second chance if thefirst-period effort fails, she has an incentive to withhold R 2 /(8·c 2 ) first-period effort at everywage level.Anticipating the effort given wage, the firm maximizesΠ| F F=RETAIN= e ∗ ( w 1 1 )·(R − w 1 ) + [1 − e ∗ ( w 1 1 )]·π ∗ ( 0, 0 ) − I 2 1= w1c − R2·(R − w8·c 2 1 ) + 1 − w 1c + R2 R2·8·c 2 4·c − I 2 − I 1 ,which implies a profit-maximizing wage of w ∗ 1 = R + I 2 /2 − R 2 /(16·c) > 0. Given this wage,the optimal managerial effort ise ∗ 1 = R + I 22·c− 3·R216·c 2 ,yielding maximized profits of Π| F F=RETAIN( e ∗ ) (Appendix equation A.2). Note that first-period1wages are higher here than in the case where the incumbent is fired, reflecting the firm’sattempt to dampen managerial moral hazard with higher wages. Nevertheless, the higher wageonly helps somewhat—first-period managerial effort remains lower than when the manager isfired.Comparing subcases 2 and 3 yields the following lemma:Lemma 1 If the incumbent and replacement are equally productive, in the absence of governmentintervention, the firm should replace the incumbent manager whenever it restarts the project.(In Section 4.1, we consider cases in which the incumbant is more productive than the potentialreplacement.) Lemma 1 establishes the optimality of firing the manager after a first-periodfailure in the absence of government intervention. This is the case even though we do notassume that the firm learns about managerial (lack of) ability from the first-period failure.Intuitively, the credible threat to fire the manager induces greater managerial effort (and lessmoral hazard) in the first period, because the manager correctly perceives that she has onlyone chance to succeed. As long as a replacement manager is equally efficient (e.g., faces thesame marginal effort costs), then the firm’s second period payoffs are the same regardless ofwhether it is managed by the incumbent manager or her replacement.Thus, when restarts are profitable and the government does not intervene, the firm alwaysfires the incumbent upon a restart, and the firm’s initial investment decision isρ ∗ = IN if Π| F F=FIRE( e ∗ ) ≥ 0 , 1.1OUT otherwise .As already mentioned, equal efficiency of managerial replacements sidesteps any time consistency(commitment) problems by the firm (and later the government). Given that the original16