nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2008‒07‒30
eleven papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Incentive compatible mechanisms in multiprincipal multiagent games By Gwenaël Piaser
  2. Stochastic and Deterministic Menus in Common Agency games: A corrected version By Gwenaël Piaser
  3. Multitasking, Quality and Pay for Performance By Kaarboe, Oddvar Martin; Siciliani, Luigi
  4. How Bankruptcy Punishment Influences the Ex-Ante Design of Debt Contracts? By Régis Blazy; Gisèle Umbhauer; Laurent Weill
  5. Optimal takeover contests with toeholds By Gino Loyola
  6. Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims By Harold L. Cole
  7. Lowest Unique Bid over the Internet: Ability, Lottery or Scam? By Andrea Gallice
  8. Too Few Cooks Spoil the Broth: Division of Labour and Directed Production By Marisa Ratto; Wendelin Schnedler
  9. Sequential Cheap Talk from Advisors with Reputation By Junghun Cho
  10. Endogenous information, menu costs and inflation persistence By Yuriy Gorodnichenko
  11. Executive Compensation and Stock Options: An Inconvenient Truth By Jean-Pierre Danthine; John B. Donaldson

  1. By: Gwenaël Piaser (CREFI-LSF, University of Luxembourg)
    Abstract: It is argued that the revelation principle in multi-principal multi-agent games cannot be generalized. In other words, one cannot restrict attention to incentive compatible mechanisms, even if the concept of information is enlarged.
    Keywords: Direct Mechanims, Incentive compatible, Multiprincipals.
    JEL: D82
    Date: 2008
  2. By: Gwenaël Piaser (CREFI-LSF, University of Luxembourg)
    Abstract: In this note we argue that in Common Agency games, the restriction to deterministic menus is crutial.We give an simple example (complete information, no moral hazard) in which an equilibrium is not robust to the introduction of stochastic menus.
    Keywords: Delegation Principle, Menus, Lotteries.
    JEL: D82
    Date: 2008
  3. By: Kaarboe, Oddvar Martin; Siciliani, Luigi
    Abstract: We present a model of optimal contracting between a purchaser and a provider of health services when quality has two dimensions. We assume that one dimension of quality is verifiable (dimension 1) and one dimension is not verifiable (dimension 2). We show that the power of the incentive scheme for the verifiable dimension depends critically on the extent to which quality 1 increases or decreases the provider's marginal disutility and the patients' marginal benefit from quality 2 (i.e. substitutability or complementarity). Our main result is that under some circumstances a high-powered incentive scheme can be optimal even when the two quality dimensions are substitutes.
    Keywords: altruism; pay for performance; quality
    JEL: D82 I11 I18 L51
    Date: 2008–07
  4. By: Régis Blazy (CREFI-LSF, University of Luxembourg); Gisèle Umbhauer; Laurent Weill
    Abstract: This research investigates how the legal sanctions prevailing under bankruptcy code impact on the design of debt contacts. Unlike most papers considering a passive behavior of the bank in case of default of the borrower, we assume the bank actively trades off between private renegotiation and costly bankruptcy procedure. Besides, the debtor’s investment policy – with a risk of asset substitution – and the creditor’s financial policy – endogenous interest rate – are explicitly modeled. The model focuses on three possible equilibriums. The first one encompasses situations where the firms stay with the best investment project (economic efficiency) and bankruptcy costs are avoided through private renegotiation (legal efficiency): this equilibrium requires a condition on bankruptcy costs and is independent of legal sanctions. A second equilibrium cover situations where the firms turn to the less profitable and riskiest project (economic inefficiency) and the default is still privately solved (legal efficiency): to avoid suboptimal investment, a minimal level of legal sanctions, whose threshold value depends on the interest rate, must apply. Last, we consider mixed strategies on the investment policy (partial economic efficiency): when financial distress occurs, two bargaining equilibriums prevail – pooling or separating – so costly bankruptcy may apply (legal inefficiency). Simulated results illustrate how the bank finally chooses between these equilibriums while the legal environment becomes more severe. First, as expected, when sanctions are getting higher, the probability of choosing the best project increases: simulations provide minimal levels of sanctions which guarantee the occurrence of the best equilibrium. As a result, extreme severity is not needed to ensure both economic and legal efficiency. Second, an increase of legal sanctions is likely to reduce the contractual interest rate, as the bank is more protected by the law, and cannot charge a risk premium anymore. A noteworthy consequence is that the debtor benefits in some extent of increased severity, as he is inclined to invest in the most profitable projects and, consequently, pays a lower interest rate. Third, a slight change of the legal environment may involve a drastic adjustment of financial variables, so that small changes in the law may involve financial instability.
    Keywords: Bankruptcy, Credit Lending, Interest Rate, Moral Hazard, Legal Sanctions
    JEL: G33 D82 D21
    Date: 2008
  5. By: Gino Loyola
    Abstract: This paper characterizes how a target firm should be sold when the possible buyers (bidders) have prior stakes in its ownership (toeholds). We find that the optimal mechanism needs to be implemented by a non-standard auction which imposes a bias against bidders with high toeholds. This discriminatory procedure is such that the target´s average sale price is increasing in both the size of the common toehold and the degree of asymmetry in these stakes. It is also shown that a simple mechanism of sequential negotiation replicates the main properties of the optimal procedure and yields a higher average selling price than the standard auctions commonly used in takeover battles.
    Keywords: Optimal auctions, Takeovers, Toeholds, Asymmetric auctions
    JEL: C72 D44 D82 G32 G34
    Date: 2008–02
  6. By: Harold L. Cole (Department of Economics, University of Pennsylvania)
    Abstract: We study the incentive issues associated with self-enforcing stochastic monitoring in a model of investment and production. The efficient contract features a debt-like payment with a threshold in terms of the reported output in which all of the reported output is taken up to the threshold if monitoring doesn’t occur and all of the output is taken if monitoring does occur. An output report above the threshold leads to zero probability of monitoring and just the threshold amount being paid out. The efficiency gap between the self-enforcing contract and the commitment constraint is minimized when the monitors holds no part of the residual claim on the firm, which we associate with equity. Misreporting by the manager is an important component of the efficient contract.
    Keywords: Capital Structure, Monitoring, Incentives, Self-Fulfilling
    JEL: G32 D82 D86
    Date: 2008–07–14
  7. By: Andrea Gallice
    Abstract: A lowest unique bid auction allocates a good to the agent who submits the lowest bid that is not matched by any other bid. This peculiar auction format is getting increasingly popular over the internet. We show that such a selling mechanism is unprofitable if bidders are rational but can become highly lucrative if bidders are myopic. In this second case, we analyze the key role played by the existence of some private signals that the seller sends to the bidders. Data about actual auctions confirm the profitability of the mechanism and the bounded rationality of the bidders.
    Keywords: Lowest Unique Bid Auctions, Signals, Bounded Rationality.
    JEL: D44 C72 D82
    Date: 2008–06
  8. By: Marisa Ratto (Université Paris-Dauphine (SDFi)); Wendelin Schnedler (University of Heidelberg, Department of Economics)
    Abstract: How can a manager influence workers' activity while knowing little about it? This paper examines a situation where production requires several tasks, and the manager wants to direct production to achieve a preferred allocation of effort across tasks. However, the effort that is required for each task cannot be observed, and the production result is the only indicator of worker activity. This paper illustrates that in this situation, the manager cannot implement the preferred allocation with a single worker. On the other hand, the manager is able to implement the preferred allocation by inducing a game among several workers. Gains to workers from collusion may be eliminated by an ability-dependent, but potentially inefficient, task assignment. These findings provide a new explanation for the division of labor, and bureaucratic features such as "over"-specialization and "wrong" task allocation.
    Keywords: specialization, job design, moral hazard, multitasking
    JEL: D02 D86 M54 D23 L23 J23
    Date: 2008–07
  9. By: Junghun Cho
    Abstract: I examine two-period sequential cheap talk in situations where the decision maker seeks advice from two advisors, each of whom knows the type of the other advisor. By considering the current payoff (which is determined by the message of each advisor) and the future payoff (which is connected with the reputation of each advisor), I examine conditions which guarantee the existence of both good and bad reputation effects. Compared to situations of simultaneous cheap talk, the decision maker loses information more easily if he seeks advice sequentially.
    Keywords: Cheap talk, reputation.
    JEL: D82 D83
    Date: 2008–06
  10. By: Yuriy Gorodnichenko
    Abstract: This paper develops a model where firms make state-dependent decisions on both pricing and acquisition of information. It is shown that when information is not perfect, menu costs combined with the aggregate price level serving as an endogenous public signal generate rigidity in price setting even when there is no real rigidity. Specifically, firms reveal their information to other firms by changing their prices. Because the cost of changing price is borne by a firm but the benefit from better information goes to other firms, firms have an incentive to postpone price changes until more information is revealed by other firms via the price level. The information externality and menu costs reinforce each other in delaying price adjustment. As a result, the response of inflation to nominal shocks is both sluggish and hump-shaped. The model can also qualitatively capture a number of stylized facts about price setting at the micro level and inflation at the macro level.
    JEL: D82 D83 E31 E52
    Date: 2008–07
  11. By: Jean-Pierre Danthine (Swiss Finance Institute, University of Lausanne and CEPR); John B. Donaldson (Columbia University)
    Abstract: We reexamine the issue of executive compensation within a gen- eral equilibrium production context. Intertemporal optimality places strong restrictions on the form of a representative manager's compen- sation contract, restrictions that appear to be incompatible with the fact that the bulk of many high-proffile managers' compensation is in the form of various options and option-like rewards. We therefore measure the extent to which a convex contract alone can induce the manager to adopt near-optimal investment and hiring decisions. To ask this question is essentially to ask if such contracts can effectively align the stochastic discount factor of the manager with that of the shareholder-workers. We detail exact circumstances under which this alignment is possible and when it is not.
    Keywords: corporate governance, optimal contracting, business cycles
    JEL: E32 E44
    Date: 2008–06

This nep-cta issue is ©2008 by Simona Fabrizi. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.