COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 729 "Managerial Incentives and Capital Management" Bengt Holmstrom and Joan E. Ricart-Costa November 1984 In Holmstrom (1982) an example is given, which shows that a manager's concern for the
value of his human capital will lead to a natural incongruity in risk-preferences between
himself and the owners, even when no effort considerations are involved. In this paper we
present a formal model of this channel of incongruity based on learning about managerial
talent. We also explore the nature of an optimal incentive contract in the case where the
manager may withhold but not misrepresent information about investment returns. The
optimal contract is an option on the manager’s human capital value with a possible
bonus for investing. The optimal investment rule accepts fewer investments than under the
cost of capital — a commonly observed real world feature. Another phenomena the model
helps explain is the extensive use of capital budgeting and rationing schemes in place of
linear or non-linear price decentralization, which are shown to be less efficient modes of
allocation. |
