Institutional Frictions and Firm Size in a Relational Contracting Model

Abstract

The Corporate Finance literature has amassed empirical evidence that firms tend to be “too large”. A large number of theoretical contributions have aimed to explain this stylized fact. Most of these explanations have focused on managers’ tendencies to overinvest, reflecting a fundamental agency problem between shareholders and managers. The present paper shows that observed overinvestments are not necessarily the (negative) consequence of agency problems between shareholders and managers. Instead, they might actually be an optimal response to a weak institutional environment - for example if court-enforceable contracts are hard to write or financial markets are underdeveloped and increase firm value by increasing the firm’s financial flexibility.