Firm Value and Corporate Governance: Does the Former Determine the Latter?

A model of corporate governance must explain (i) why governance matters; (ii) variation in governance across firms (i.e., be responsive to the Demsetz and Lehn, 1985, critique); and (iii) the positive correlations found empirically between quality of corporate governance and corporate performance. The model presented here satisfies these three criteria. Moreover, the model explains the correlation between firm size and executive compensation and why empirical estimates of managerial incentives seem too low, among other phenomena.