We study the relation of financial contracting and the pace of technologicaladvance in a dynamic agency theoretic model. A firm which is financed byoutside shareholders but run by managers has the prospect of a processinnovation which arrives stochastically. Adopting the innovation requiresfiring old management and hiring new with skills appropriate for the newtechnique. We show that subgame perfect equilibria in this game can be oftwo types. In “entrenchment” equilibrium once the new technique has beenannounced old style management raises their dividend payout sufficiently topreempt the innovation. In “maximum rent extraction” equilibrium’ managersare unable or unwilling to match the impending productivity improvement andinstead respond by increasing their perquisites for the remaining time oftheir tenure. We show that both equilibria involve several types ofinefficiencies and can result in underinvestment in positive NPV projects.We discuss the role of financial innovation in reducing the inefficienciesidentified.
