Efficiency in a Monotonic Partnership with Investment: An Endogenous Implementation of Holmstrom’s Principal

Abstract

This note presents a model of a partnership that requires initial investment. The production technology depends on partners’ effort choices and, possibly, on an exogenous stochastic term. When the technology is monotonic, the paper shows that the need for an investor is a sufficient condition to ensure efficiency. Efficient sharing rules arise endogenously as outcomes of optimal contracts between the investor and the partners. This result illustrates how a Principal-agent structure can naturally arise in a partnership, without changing its basic internal structure. Indeed, the investor emerges as an (external) implementation of a budget-breaker Principal that solves the inefficiency problem inherent to partnerships, as suggested in Holmström (1982).