Long-Term Contracts, Short-Term Investment and Monitoring.

This paper presents a dynamic contracting model of myopic firm behavior caused by the fear of early project termination by outside investors. Although the parties can conclude long-term contracts, asymmetric information between investors and firms can make it impossible to implement profitable long-term projects. The paper characterizes the structure of optimal, renegotiation-proof debt contracts for unmonitored and monitored finance. Monitoring by investors, although itself subject to distorting incentive constraints, is shown to be able to overcome the short-term bias of investment and thus to lengthen the firms' planning horizon. Copyright 1995 by The Review of Economic Studies Limited.