Ambiguity Aversion, Disagreement, and the Theory of the Firm∗

We present a novel source of disagreement grounded in decision theory: ambiguity aversion. We show that ambiguity aversion generates endogenous disagreement between a firm’s insider and outside shareholders, creating a new rationale for corporate governance systems. In our paper, optimal corporate governance depends on both firm characteristics and the composition of the outsiders’overall portfolio. A strong governance system is desirable when the value of the firm’s assets in place, relative to the growth opportunity, is suffi ciently small or is suffi ciently large, suggesting a corporate governance life cycle. In addition, more diversified outsiders (such as generalist mutual funds) prefer stronger governance, while outsiders with a portfolio heavily invested in the same asset class as the firm (such as venture capitalists or private equity investors) are more willing to tolerate a weak governance system, where the portfolio companies’insiders have more leeway in determining corporate policies. Finally, we find that ambiguity aversion introduces a direct link between the strength of the corporate governance system and firm transparency, whereby firms with weaker governance should also optimally be more opaque. ∗We would like to thank Jonathan Berk, Diego Garcia, Lorenzo Garlappi, Ron Giammarino, Christopher Hennessy, Ali Lazrak, Doron Levit, Kevin Murphy, Jacob Sagi, Merih Sevilir, Anjan Thakor, Geoff Tate, and seminar participants at the UNC Brown Bag Seminar, UBC Winter Finance Conference, the University of Houston, the Finance, Organizations, and Markets Conference, and Miami Behavioral Finance Conference for very helpful comments. All errors are only our own. We can be reached at David_Dicks@kenan-flagler.unc. edu and Paolo_Fulghieri@kenanflagler.unc. edu Disagreement adds spice to life. Differences of opinions among economic agents are an important driver of trades in financial markets, where agents hold different “beliefs”on the future performance of securities, and the design of corporate financial structures, where agents respond to differences in valuation of firms’investment opportunities. While financial economists have long recognized the importance of disagreement, there is lack of consensus on the source of such disagreement. In this paper, we derive endogenous disagreement from ambiguity aversion and apply our finding to the question of allocation of control within a firm. Differences of opinion may reflect differences of information among economic agents (e.g., Grossman, 1976). They may also reflect the fact that economic agents hold heterogeneous priors, or that they have a different interpretation of the same facts (see Harris and Raviv, 1993, Morris, 1994 and 1995, Kandel and Pearson, 1995, and more recently Van den Steen 2009). A common feature of the second group of papers is that differences of opinion are determined exogenously, by endowing agents either with heterogeneous priors or with different updating rules (i.e., different likelihood functions) used to form posteriors beliefs. As a result, agents hold different “views of the world,” which leads them to differences of opinion.1 In this paper, we present a novel source of disagreement that is grounded in decision theory: ambiguity aversion. We argue that ambiguity aversion generates endogenous differences of beliefs among agents.2 Our economy is populated by agents who are endowed with the same set of “core beliefs,”but are heterogeneous in other dimensions, such as endowments.3 We show that agents’ heterogeneity generates differences of beliefs as the outcome of their different exposure to risk factors in the economy. We assume that this difference in risk exposure cannot be resolved contractually due to contractual frictions or incompleteness.4 The key benefit of our approach is that ambiguity aversion creates a direct link between differences of beliefs and economic fundamentals, allowing us to study the effect of changes in fundamentals on disagreement among agents.5 Models with heterogenous prisors are also common in the asset pricing literature. See, for example, Harrison and Kreps (1978), Detemple and Murthy (1994), Basak (2000), and David (2008), among many others. 2 In our model, economic agents disagree in the sense that they have different de Finetti probabilities; see, for example, de Finetti (1974). Alternatively, agents’heterogeneity may derive from differences in preferences, such as risk attitudes, or skills (ability), a route that we do not follow in this paper. An example of such contractual incompleteness is the limited ability to insure insiders’human capital. Our paper has also implications for the question of the persistence of disagreement over time in cases where agents observe (infinitely many) signals on uncertain payoff-relevant parameters (see, for example, Cripps et al., 2008, and Acemoglu, Chernozukov, and Yildiz, 2009). Specifically, our model suggests that if agents’ heterogeneity persists