Introduction 2. The static model 3. Collusion 4. Concluding remarks Appendix A: Cartel stability ... more Introduction 2. The static model 3. Collusion 4. Concluding remarks Appendix A: Cartel stability with large price cuts * This paper originates from chapter 4 of my Ph.D. thesis at the London School of Economics (Raith 1996). I would like to thank John Sutton for his guidance throughout the paper's evolution, and Patrick Bolton and especially Leonardo Felli and Paul Klemperer for their very constructive suggestions. For comments on this or previous versions, I am also indebted to Guido Friebel, Godfrey Keller, Sougata Poddar, George Symeonidis, and seminar participants at various occasions. Any remaining errors are my own. Financial support by the Suntory and Toyota International Centres for Economics and Related Disciplines (at LSE) and by the European Commission (through its Human Capital and Mobility Programme) is gratefully acknowledged.
We analyze how the availability of internal funds affects a firm's investment. We show that under... more We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.
Capital Budgeting, Project Risk and Managerial Incentives
A major interface between finance andoperations is a firm's capital justification process for... more A major interface between finance andoperations is a firm's capital justification process forinvestments, by which we mean the set of activities to evaluate andapprove a project proposal, and to tie the project's performance tomanagers' incentives. We study how project risk interacts withagency problems associated with managers who propose and executeprojects. This is important for operations projects due to today's rapidly changing markets and bytechnological change. Our main insight is that even for arisk-neutral firm, riskier projects are less profitable becausethey are associated with higher costs of providing incentives tomanagers.We study a principal-agent model in which the agent is a manager whoproposes a project and, if approved, oversees its execution, and inwhich the principal is the firm or its general management. We showthat both when the agent is risk-neutral but protected by limitedliability, and when the agent is risk averse, higher project risk isass...
This paper studies how the investment of a financially constrained firm responds to changes in th... more This paper studies how the investment of a financially constrained firm responds to changes in the constraints it faces. We distinguish between changes in the firm's internal funds and changes in the extent of asymmetric information between the firm and an outside investor. The financial contract between firm and investor, and thus the cost of raising external funds, are derived endogenously. We show that changes in internal funds and informational asymmetry have different effects on the marginal cost of external funds and therefore the firm's optimal investment. More asymmetric information generally leads to lower investment and a greater sensitivity of investment to changes in internal funds. The relationship between internal funds and investment, in contrast, is U-shaped: depending on the level of a firm's internal funds, a decrease in internal funds may lead to decreased, unchanged, or even increased investment. Our predictions are supported by empirical evidence and explain seemingly contradictory findings in the recent empirical literature.
We study financial contracting when both an entrepreneur's investment and the resulting revenue a... more We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. Moreover, when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the decision concerns managerial effort or project risk, however, it may be optimal to write a contract with a greater threat of liquidation, to induce the entrepreneur to exert more effort or to choose a less risky project.
Journal of Financial and Quantitative Analysis, 2007
We analyze how the availability of internal funds affects a firm's investment. We show that u... more We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.
International Journal of Industrial Organization, 2004
This paper analyzes the interaction of financing and output market decisions in a duopoly in whic... more This paper analyzes the interaction of financing and output market decisions in a duopoly in which one firm is financially constrained and can borrow funds to finance production costs. Two ideas have been separately analyzed in previous work: Some authors argue that debt strategically affects a firm's output market decisions, typically making it more aggressive; others argue that the threat of bankruptcy makes debt financing costly, typically making a firm less aggressive. Our model integrates both ideas; moreover, unlike most previous work, we derive debt as an optimal contract. Compared with a situation in which both firms are unconstrained, the constrained firm produces less, while its unconstrained rival produces more; prices are higher for both firms. Both firms' outputs depend on the constrained firm's internal funds; the relationship is U-shaped for the constrained firm and inversely U-shaped for its unconstrained rival. The unconstrained rival has a higher market share, not because of predation but because of the cost disadvantage of the financially constrained firm.
This paper develops a model of successive oligopolies with endogenous entry, allowing for varying... more This paper develops a model of successive oligopolies with endogenous entry, allowing for varying degrees of product differentiation and entry costs in both markets. Our analysis shows that the downstream conditions dominate the overall profitability of the two-tier structure while the upstream conditions mainly affect the distribution of profits. We compare the welfare effects of upstream versus downstream deregulation policies and show that the downstream deregulation is more effective if the industry is relatively concentrated and vice versa. Furthermore, we analyze how different forms of vertical restraints shape the endogenous market structure and provide conditions under which they are welfare reducing.
This article studies strategic bargaining in which a seller and a buyer are each represented by a... more This article studies strategic bargaining in which a seller and a buyer are each represented by an agent. Potential agents differ in their ability to obtain information about the other party's reservation price; neither principal knows the other's reservation price or her agent's type. Agents are motivated by career concerns; they want to be perceived as skilled bargainers by their principals. In equilibrium, skilled agents use their private information optimally, while unskilled agents randomize between aggressive and soft price bids, attempting to imitate skilled types. We compare ' 'open-door' ' bargaining, in which principals can observe the entire bargaining game as well as its outcome, with ' 'closed-door' ' bargaining, in which they observe only the outcome. We show that agents unambiguously bargain more aggressively with open doors than behind closed doors, which leads to a less efficient bargaining outcome. Their principals may therefore prefer to let their agents bargain behind closed doors.
If managers and their subordinates had the same basic qualifications, organizations could benefit... more If managers and their subordinates had the same basic qualifications, organizations could benefit from replacing unproductive superiors with more productive subordinates. This threat of being replaced, however, could give rise to strategic recruiting: Unproductive superiors might deliberately recruit unproductive subordinates in order to protect themselves, or engage in other forms of abuse of authority which could be harmful to the organization. We show that the common practice of requiring intra-firm communication to pass through a chain of command can be an effective way to secure the incentives for superiors to recruit the best possible subordinates. We discuss some alternative instruments and general implications of our analysis for organizational design.
the 2006 IIOC and NAES meetings and the Christmas Meeting of German Expatriate Economists, and th... more the 2006 IIOC and NAES meetings and the Christmas Meeting of German Expatriate Economists, and the 2007 Research Workshop on Industrial Organization and Finance in Barcelona and the ESSET in Gerzensee, for very helpful comments and suggestions. The first draft was written while Raith was visiting the Marshall School of Business at USC, and we would like to thank the school for its hospitality.
We propose a theory that emphasizes the role of managers for the production and allocation of hum... more We propose a theory that emphasizes the role of managers for the production and allocation of human capital in …rms. Managers invest time to train junior employees, and acquire information about the juniors'abilities that is valuable for job assignments. This dual role of managers matters especially in a multidivisional …rm, whose internal labor market may be structured in two distinct ways. In a "silo," junior workers are eligible only for a transfer or promotion in the division they currently work in; in a "lattice," they can also be assigned to another division. The prospect of losing a good worker to another division undermines a manager's training incentives, and may encourage her to misrepresent the information she provides about her workers. We show that because of these agency problems, implementing a lattice to achieve better job assignments also leads to higher wage costs for the …rm. As a result, either silos or a lattice can be optimal. Our comparative-statics analysis suggests that the recent trend for …rms to facilitate crossdivisional mobility may be caused by product market competition, a tight managerial labor market, and skill-biased technological change.
We propose a theory of production and allocation of human capital in firms that focuses on the ro... more We propose a theory of production and allocation of human capital in firms that focuses on the role of line managers, who both invest time to mentor junior employees, and acquire information about the juniors’abilities that is valuable for job assignments. We argue that this dual role of managers implies that internal labor markets and incentive contracts for managers must be determined jointly. Specifically, an internal labor market may be structured in two distinct ways: in a “silo,”junior workers are eligible only for a transfer or promotion in the division they currently work in; in a “lattice,”they can also be assigned to another division. Ṫhe prospect of losing a good worker to another division undermines a managers’s mentoring incentives, and may encourage her to misrepresent strategically information she provides about her workers. A lattice therefore leads to better job assignments but entails greater agency costs for the firm. Both silos or a lattice can be optimal. Our analysis suggests several reasons that may help explain a recent trend for firms to switch from silos to lattices with cross-divisional mobility.
Stole, Jean Tirole and many seminar audiences. Any remaining errors are our own. Finally, we woul... more Stole, Jean Tirole and many seminar audiences. Any remaining errors are our own. Finally, we would like to thank the European Commission and the Communauté Française de Belgique for financial support.
Introduction 2. The static model 3. Collusion 4. Concluding remarks Appendix A: Cartel stability ... more Introduction 2. The static model 3. Collusion 4. Concluding remarks Appendix A: Cartel stability with large price cuts * This paper originates from chapter 4 of my Ph.D. thesis at the London School of Economics (Raith 1996). I would like to thank John Sutton for his guidance throughout the paper's evolution, and Patrick Bolton and especially Leonardo Felli and Paul Klemperer for their very constructive suggestions. For comments on this or previous versions, I am also indebted to Guido Friebel, Godfrey Keller, Sougata Poddar, George Symeonidis, and seminar participants at various occasions. Any remaining errors are my own. Financial support by the Suntory and Toyota International Centres for Economics and Related Disciplines (at LSE) and by the European Commission (through its Human Capital and Mobility Programme) is gratefully acknowledged.
We analyze how the availability of internal funds affects a firm's investment. We show that under... more We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.
Capital Budgeting, Project Risk and Managerial Incentives
A major interface between finance andoperations is a firm's capital justification process for... more A major interface between finance andoperations is a firm's capital justification process forinvestments, by which we mean the set of activities to evaluate andapprove a project proposal, and to tie the project's performance tomanagers' incentives. We study how project risk interacts withagency problems associated with managers who propose and executeprojects. This is important for operations projects due to today's rapidly changing markets and bytechnological change. Our main insight is that even for arisk-neutral firm, riskier projects are less profitable becausethey are associated with higher costs of providing incentives tomanagers.We study a principal-agent model in which the agent is a manager whoproposes a project and, if approved, oversees its execution, and inwhich the principal is the firm or its general management. We showthat both when the agent is risk-neutral but protected by limitedliability, and when the agent is risk averse, higher project risk isass...
This paper studies how the investment of a financially constrained firm responds to changes in th... more This paper studies how the investment of a financially constrained firm responds to changes in the constraints it faces. We distinguish between changes in the firm's internal funds and changes in the extent of asymmetric information between the firm and an outside investor. The financial contract between firm and investor, and thus the cost of raising external funds, are derived endogenously. We show that changes in internal funds and informational asymmetry have different effects on the marginal cost of external funds and therefore the firm's optimal investment. More asymmetric information generally leads to lower investment and a greater sensitivity of investment to changes in internal funds. The relationship between internal funds and investment, in contrast, is U-shaped: depending on the level of a firm's internal funds, a decrease in internal funds may lead to decreased, unchanged, or even increased investment. Our predictions are supported by empirical evidence and explain seemingly contradictory findings in the recent empirical literature.
We study financial contracting when both an entrepreneur's investment and the resulting revenue a... more We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. Moreover, when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the decision concerns managerial effort or project risk, however, it may be optimal to write a contract with a greater threat of liquidation, to induce the entrepreneur to exert more effort or to choose a less risky project.
Journal of Financial and Quantitative Analysis, 2007
We analyze how the availability of internal funds affects a firm's investment. We show that u... more We analyze how the availability of internal funds affects a firm's investment. We show that under fairly standard assumptions, the relation is U-shaped: investment increases monotonically with internal funds if they are large but decreases if they are very low. We discuss the tradeoff that generates the U-shape, and argue that models predicting an always increasing relation are based on restrictive assumptions. Using a large data set, we find strong empirical support for our predictions. Our results qualify conventional wisdom about the effects of financial constraints on investment behavior, and help to explain seemingly conflicting findings in the empirical literature.
International Journal of Industrial Organization, 2004
This paper analyzes the interaction of financing and output market decisions in a duopoly in whic... more This paper analyzes the interaction of financing and output market decisions in a duopoly in which one firm is financially constrained and can borrow funds to finance production costs. Two ideas have been separately analyzed in previous work: Some authors argue that debt strategically affects a firm's output market decisions, typically making it more aggressive; others argue that the threat of bankruptcy makes debt financing costly, typically making a firm less aggressive. Our model integrates both ideas; moreover, unlike most previous work, we derive debt as an optimal contract. Compared with a situation in which both firms are unconstrained, the constrained firm produces less, while its unconstrained rival produces more; prices are higher for both firms. Both firms' outputs depend on the constrained firm's internal funds; the relationship is U-shaped for the constrained firm and inversely U-shaped for its unconstrained rival. The unconstrained rival has a higher market share, not because of predation but because of the cost disadvantage of the financially constrained firm.
This paper develops a model of successive oligopolies with endogenous entry, allowing for varying... more This paper develops a model of successive oligopolies with endogenous entry, allowing for varying degrees of product differentiation and entry costs in both markets. Our analysis shows that the downstream conditions dominate the overall profitability of the two-tier structure while the upstream conditions mainly affect the distribution of profits. We compare the welfare effects of upstream versus downstream deregulation policies and show that the downstream deregulation is more effective if the industry is relatively concentrated and vice versa. Furthermore, we analyze how different forms of vertical restraints shape the endogenous market structure and provide conditions under which they are welfare reducing.
This article studies strategic bargaining in which a seller and a buyer are each represented by a... more This article studies strategic bargaining in which a seller and a buyer are each represented by an agent. Potential agents differ in their ability to obtain information about the other party's reservation price; neither principal knows the other's reservation price or her agent's type. Agents are motivated by career concerns; they want to be perceived as skilled bargainers by their principals. In equilibrium, skilled agents use their private information optimally, while unskilled agents randomize between aggressive and soft price bids, attempting to imitate skilled types. We compare ' 'open-door' ' bargaining, in which principals can observe the entire bargaining game as well as its outcome, with ' 'closed-door' ' bargaining, in which they observe only the outcome. We show that agents unambiguously bargain more aggressively with open doors than behind closed doors, which leads to a less efficient bargaining outcome. Their principals may therefore prefer to let their agents bargain behind closed doors.
If managers and their subordinates had the same basic qualifications, organizations could benefit... more If managers and their subordinates had the same basic qualifications, organizations could benefit from replacing unproductive superiors with more productive subordinates. This threat of being replaced, however, could give rise to strategic recruiting: Unproductive superiors might deliberately recruit unproductive subordinates in order to protect themselves, or engage in other forms of abuse of authority which could be harmful to the organization. We show that the common practice of requiring intra-firm communication to pass through a chain of command can be an effective way to secure the incentives for superiors to recruit the best possible subordinates. We discuss some alternative instruments and general implications of our analysis for organizational design.
the 2006 IIOC and NAES meetings and the Christmas Meeting of German Expatriate Economists, and th... more the 2006 IIOC and NAES meetings and the Christmas Meeting of German Expatriate Economists, and the 2007 Research Workshop on Industrial Organization and Finance in Barcelona and the ESSET in Gerzensee, for very helpful comments and suggestions. The first draft was written while Raith was visiting the Marshall School of Business at USC, and we would like to thank the school for its hospitality.
We propose a theory that emphasizes the role of managers for the production and allocation of hum... more We propose a theory that emphasizes the role of managers for the production and allocation of human capital in …rms. Managers invest time to train junior employees, and acquire information about the juniors'abilities that is valuable for job assignments. This dual role of managers matters especially in a multidivisional …rm, whose internal labor market may be structured in two distinct ways. In a "silo," junior workers are eligible only for a transfer or promotion in the division they currently work in; in a "lattice," they can also be assigned to another division. The prospect of losing a good worker to another division undermines a manager's training incentives, and may encourage her to misrepresent the information she provides about her workers. We show that because of these agency problems, implementing a lattice to achieve better job assignments also leads to higher wage costs for the …rm. As a result, either silos or a lattice can be optimal. Our comparative-statics analysis suggests that the recent trend for …rms to facilitate crossdivisional mobility may be caused by product market competition, a tight managerial labor market, and skill-biased technological change.
We propose a theory of production and allocation of human capital in firms that focuses on the ro... more We propose a theory of production and allocation of human capital in firms that focuses on the role of line managers, who both invest time to mentor junior employees, and acquire information about the juniors’abilities that is valuable for job assignments. We argue that this dual role of managers implies that internal labor markets and incentive contracts for managers must be determined jointly. Specifically, an internal labor market may be structured in two distinct ways: in a “silo,”junior workers are eligible only for a transfer or promotion in the division they currently work in; in a “lattice,”they can also be assigned to another division. Ṫhe prospect of losing a good worker to another division undermines a managers’s mentoring incentives, and may encourage her to misrepresent strategically information she provides about her workers. A lattice therefore leads to better job assignments but entails greater agency costs for the firm. Both silos or a lattice can be optimal. Our analysis suggests several reasons that may help explain a recent trend for firms to switch from silos to lattices with cross-divisional mobility.
Stole, Jean Tirole and many seminar audiences. Any remaining errors are our own. Finally, we woul... more Stole, Jean Tirole and many seminar audiences. Any remaining errors are our own. Finally, we would like to thank the European Commission and the Communauté Française de Belgique for financial support.
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Papers by Michael Raith