The Incentive Costs of Internalizing Externalities, Second Version
We present a dynamic agency model in which changes in the structure of a firm affect its value due to altered incentives. There may be disadvantages in merging two firms even when such a merger allows the internalization of externalities between the two firms. Merging, by making unprofitable certain decisions, increases the cost of inducing managers to exert effort. This incentive cost arises as a natural consequence of the manager's firm-specific human capital.