Price Uncertainty and Investment Behavior of Corporate Management under Risk Aversion and Preference for Prudence

The current paper reconsiders the theory of corporate investment under price uncertainty. The assumption that management is a perfect, risk-neutral agent of corporate owners has been relaxed. It is found that the management´s limited opportunity to diversify and limited ability to finance consumption by borrowing against human capital creates a mechanism which reinforces the technology effect discussed in the earlier literature calling for more current capital investment essentially functions as a precautionary mechanism for risk-averse management with a preference for prudence in conditions of imperfect spanning. The result is likely to hold under diminishing absolute risk aversion and a diminishing preference for prudence when the management participates in sharing corporate risks. The model can be viewed as marrying the neoclassical theory of investment with the managerial theory of a firm. Its key assumption is the separation of ownership and control in the sense that the that the shareholders are considered to be unable to evaluate investment projects while the management is.