Risk Sharing and the Theory of the Firm

When effort cannot be costlessly monitored, Pareto optimal employee compensation schemes require that owners and managers deviate from perfect risk sharing to improve the work incentives facing the manager. This article investigates the implications of this misallocation of risk for the behavior of firms in which managers make decisions for owners. The presented model predicts that, from the owner's perspective, managers will exhibit excessive risk aversion and underinvest in risky projects.