A Model of Optimal Corporate Bailouts - Faculty of Business and ...
A Model of Optimal Corporate Bailouts - Faculty of Business and ...
A Model of Optimal Corporate Bailouts - Faculty of Business and ...
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expropriated in case <strong>of</strong> a bailout. This is the unremediable social moral hazard inducedby government intervention.Relative to non-intervention, both the owners <strong>and</strong> the incumbent managers are worse <strong>of</strong>f. Itis only the third party stakeholders that are better <strong>of</strong>f.Panel (A) shows that, as R increases, the government can tax less <strong>and</strong> less. Panel (B) showsthat corporate pr<strong>of</strong>its approach those in the absence <strong>of</strong> intervention. Note what happens at theborder where the government is indifferent between intervening <strong>and</strong> not intervening, becausethe firm is about to continue on without government intervention. Panel B shows that if themanager is not fired, her knowledge <strong>of</strong> the firm’s desire to restart makes her slack <strong>of</strong>f in thefirst period. This causes a discontinuity for the firm. Interestingly, if the firm could commititself not to restart so early, it would be better <strong>of</strong>f, because managers would work harder in thefirst period. (Of course, if the firm could simply fire the manager, as the government does incase <strong>of</strong> a bailout, then the firm does not face this moral-hazard problem, either.)4 ExtensionsOur base model made a number <strong>of</strong> simplifying assumptions in order to isolate key intuitions. Inthis section, we generalize that model through a number <strong>of</strong> extensions in order to illustrate therobustness <strong>of</strong> our key results.4.1 Heterogeneity <strong>of</strong> ManagersIn our basic model, the replacement manager was as effective as the incumbent manager (i.e.,the cost <strong>of</strong> effort, c, was equal). Theorem 1 showed that the government optimally fires a failedmanager, because the threat <strong>of</strong> termination increases managerial effort in the first stage. Inmany situations, this is a plausible assumption, because failure may in itself be associated with(<strong>and</strong> indicate) that the original manager was not particularly good <strong>and</strong> thus not better than herpotential replacement.But we can also consider the case in which the new replacement manager (n) is not aseffective as the old incumbent manager (o), i.e., c n > c o . The firm now faces a trade<strong>of</strong>f. Thethreat <strong>of</strong> termination upon failure still improves the incumbent’s incentives in the first stage.But this needs to be weighed against the lower continuation value in the second stage—with herhigher cost <strong>of</strong> effort, the replacement will optimally work less. We now examine the conditionsunder which the government can <strong>and</strong> will want to commit 21 ex ante to firing failed managers.Complicating the social welfare trade<strong>of</strong>f is the fact that when c n > c o , the bailout accompanyingmanagerial replacement (g n ) exceeds the bailout accompanying managerial retention (g o ).21 With lower effort from the replacement, it is no longer time-consistent to fire the incumbent. Thus, we nowhave to assume an ability to commit.23