Do Firms Diversify Because Managers Shirk? A Reinterpretation of the Principal-Agent Model of Diversification

In the principal-agent model of firm structure proposed by Aron (1988), diversification is optimal because it reduces managerial risk exposure. Diversification has this effect because it improves the monitoring function of output-contingent compensation which exists to alleviate the managerial moral hazard problem facing the firm's owners. But what if managers never shirk or can be easily observed by firm owners so the moral hazard problem vanishes? Does the optimality of diversification vanish as well? This paper develops a self-selection variant of Aron's model to show that the answer to this question is no. A by-product of this exercise is that it suggests how one might craft a test of whether the principal-agent model of diversification is driven by the problem of managerial moral hazard or managerial self-selection.