A Canonical Model of Disagreement and Moral Hazard with Applications

Moral hazard and disagreement are important economic frictions. How do their individual effects on economic behavior differ and how do these frictions interact when operating together? This paper addresses these questions by developing a canonical model of disagreement (generated by heterogeneous prior beliefs) and moral hazard, and contrasts the differing implications of these two contracting frictions for the allocation of control over project choice. The model is developed in the context of an owner-manager raising external equity financing for a project. In isolation, moral hazard implies that all project-choice control is optimally allocated to investors. By contrast, disagreement, either by itself or in combination with moral hazard, implies that project-choice control should optimally rest either with the owner-manager (if the control allocation has to be “bang-bang”) or be shared between the owner-manager and investors. Three applications of the model are then analyzed: capital budgeting, mergers and acquisitions, and dividends. These applications help square the theory with unexplained stylized facts and generate several new predictions