The Neoclassical Firm Under Moral Hazard

We develop a model of the neoclassical firm under moral hazard with endogenous capital and employment and perfectly competitive capital, labor and product markets. We assume that effort becomes harder to measure as the firm gets larger and the exogenous parameters are affiliated. The model explains why incentives decline but wages rise with firm size, the mixed evidence on the risk‐reward tradeoff, and the positive correlation between wages and profits. In the long run, incentives are increasing in risk via endogenous capital. Finally, the model makes novel predictions about the relationship between incentives and labor market conditions.