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Delegation through Managerial Contracts: Is Hiring a Manager a Good Idea?

Daron  Acemoglu,  June 1992
Paper No' CEPDP0082:
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This Paper is published under the following series: CEP Discussion Papers
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Why would an entrepreneur hire a manager? It could be because managers are particularly talented people. This paper suggests another reason. We consider a model with asymmetric information between financiers and entrepreneurs which gives rise to sizable inefficiencies. Under simple conditions, both the debt and the equity markets collapse and no project is financed. Or else, all projects are financed and there is overinvestment. However when the entrepreneurs can hire managers and write publicly observable contracts leaving the financing and investment decisions to the manager, first-best efficiency is restored. We argue that this is an example of a more general phenomena that delegation of control through observable and enforceable contracts to a third party will often increase efficiency in a principle-agent type relationship.