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

expropriated in case of a bailout. This is the unremediable social moral hazard inducedby government intervention.Relative to non-intervention, both the owners and the incumbent managers are worse off. Itis only the third party stakeholders that are better off.Panel (A) shows that, as R increases, the government can tax less and less. Panel (B) showsthat corporate profits approach those in the absence of intervention. Note what happens at theborder where the government is indifferent between intervening and not intervening, becausethe firm is about to continue on without government intervention. Panel B shows that if themanager is not fired, her knowledge of the firm’s desire to restart makes her slack off 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 off, because managers would work harder in thefirst period. (Of course, if the firm could simply fire the manager, as the government does incase of a bailout, then the firm does not face this moral-hazard problem, either.)4 ExtensionsOur base model made a number of simplifying assumptions in order to isolate key intuitions. Inthis section, we generalize that model through a number of extensions in order to illustrate therobustness of our key results.4.1 Heterogeneity of ManagersIn our basic model, the replacement manager was as effective as the incumbent manager (i.e.,the cost of effort, c, was equal). Theorem 1 showed that the government optimally fires a failedmanager, because the threat of termination increases managerial effort in the first stage. Inmany situations, this is a plausible assumption, because failure may in itself be associated with(and indicate) that the original manager was not particularly good and 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 tradeoff. Thethreat of 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 of effort, the replacement will optimally work less. We now examine the conditionsunder which the government can and will want to commit 21 ex ante to firing failed managers.Complicating the social welfare tradeoff 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