Managerial Incentives, Investment and Aggregate Implications: Scale Effects

We explore a managerial model of investment behaviour in which an incentive problem arises because one input factor (managerial effort) is not publicly observed. We show that an optimal incentive contract leads to investment levels which are below first-best in low states and that this phenomenon can account for greater cyclical variability in aggregate production and investment. From the perspective of incentive scheme design, a special feature of the model is that screening takes place over two variables (investment and output) rather than one as is customary.