Executive Compensation & the Boundary of the Firm: The Case of Short-Lived Projects

We consider the problem of moral hazard in the team of managers employed in a firm when the principal/firm owner can play an active role in determining team output. Unless the principal's compensation is non-decreasing in firm value there is an additional moral hazard problem since the principal will have an incentive to reduce output. In this context we determine team, and hence firm, size and solve for the form of optimal managerial compensation contracts. In particular we determine conditions under which optimal contracts will have option-like features.