The impact of firm size on dynamic incentives and investment

Abstract

Recent studies conclude that small firms have higher but more variable growth rates than large firms. To explore how this empirical regularity affects moral hazard and investment, we develop an agency model with a firm size process having two features: the drift is controlled by the agent's effort and the principal's investment decision, and the volatility is proportional to the square root of size. The firm improves on production efficiency as it grows, and wages are back‐loaded when size is small but front‐loaded when it is large. Furthermore, there is underinvestment in a small firm but overinvestment in a large firm.