A Reconsideration of the Jensen-Meckling Model of Outside Finance. [Award for the Most Significant Paper in 2009, Journal of Financial Intermediation]

The paper studies outside finance in a model of two-dimensional moral hazard, involving risk choices as well as effort choices. If the entrepreneur has insufficient funds, a first-best outcome cannot be implemented. Second-best outcomes involve greater failure risk than first-best outcomes. For a Cobb-Douglas technology, second-best effort and investment levels are smaller than first-best; for other technologies, they depend on the elasticity of substitution. If firm returns not too noisy signals of behaviour, suitable incentives can be provided by some mix of debt and equity issues. If firm returns involve too much noise, this is not possible