This Appendix presents the proofs of the Propositions and Corrollaries from the text.
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Ralph Chami is a senior economist in the IMF Institute. Connel Fullenkamp is Visiting Professor, Department of Economics, Duke University. The authors would like to thank Ted Bergstrom, Eleanor Brown, Tom Cosimano, Andrew Feltenstein, Ken Lehn, Casey Mulligan, Paul Zak, Edda Zoli, participants at the 1999 AEA Meetings, and participants at the conference “Measuring and Managing Ethical Risk: How Investing in Ethics Adds Value,” University of Notre Dame, September 23–24, 1999, for discussions and comments on an earlier version of the paper.
In their defense, it is important to note that Jensen and Meckling (1976) and Jensen (1998) acknowledge that agency relationships permeate the firm. They focused initially on one particular relationship in order to meet the space constraints imposed by academic journals.
Funk and Wagnail’s New International Dictionary of the English Language, 1995.
In fact, if the principal tries to write a compensation contract in which the wage paid depends on the observed revenues of the firm, the results given below will not change and in fact may be strengthened.
The case in which the agent is altruistic toward the principal is the case of loyalty examined by Mulligan (1997) and discussed above. Our case complements Mulligan’s discussion by showing what may happen when a firm attempts to purchase employee loyalty.
If the wage contract is contingent on output, Jurges (2000) shows that a substitution effect is also present, which also drives effort lower. The principal in effect taxes the agent’s effort.
Introducing ownership into our static model would make the principal and agent identical.
Some may believe that this problem affects the Trusting Firm as well, because a large firm may imply that each worker must trust an expanding number of other employees. In reality, each worker works closely with a relatively small number of other employees, no matter how large the corporation. In addition, trust is formed between pairs of individuals as well as among groups of individuals, so that a chain of trust can be formed within a firm that links all of the employees together although each employee does not trust—or even know—every other employee.