Moral Hazard and Limited Liability: Implications for the Theory of the Firm

This paper presents a theory of the firm based on moral hazard in the provision of effort by an owner-manager who borrows money in financial markets under conditions of limited liability. The authors examine the relationship between the financial structure of the firm and the effort and output decisions of the owner-manager. Results are reported concerning the determination of the firm's optimal financial structure, and concerning the positive and normative implications of financial structure for pure competition and monopoly. They also identify a strategic advantage from equity finance under Cournot oligopoly. Copyright 1989 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.