nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2009‒04‒05
sixteen papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. The value of a "free" customer By Sunil Gupta; Carl F. Mela; Jose M. Vidal-Sanz
  2. The Equivalence between the Core and the Equilibria of a Noncooperative Game with Competing Contracts By Zheng, Charles Zhoucheng
  3. The Optimal State Aid Control: No Control By Martin Gregor; Dalibor Roháč
  4. Optimal Auctions with Financially Constrained Bidders By Mallesh M. Pai; Rakesh Vohra
  5. Fee Setting Intermediaries: On Real Estate Agents, Stock Brokers, and Auction Houses By Simon Loertscher; Andras Niedermayer
  6. Self-Enforcing Trade Agreements and Private Information By Kyle Bagwell
  7. Contract renewal as an incentive device. An application to the French urban public transport sector By GAUTIER, Axel; YVRANDE-BILLON, Anne
  8. Learning from post-trade identity disclosure in electronic trading By Menkhoff, Lukas; Schmeling, Maik
  9. Multiple-bidding in auctions as bidders become confident of their private valuations By Christopher Cotton
  10. Deterrence of a criminal team: how to rely on its members’shortcomings ? By Eric Langlais
  11. Foreign Bank Entry: The Stability Implications of Greenfield Entry vs. Acquisition By Nikolaj Schmidt
  12. Deterrence of a criminal team: how to rely on its members' shortcomings? By Langlais, Eric
  13. Adverse Selection and Risk Aversion in Capital Markets By Braido, Luis; da Costa, Carlos; Dahlby, Bev
  14. Confronting Objections to Performance Pay: A Study of the Impact of Individual and Gain-sharing Incentives on the Job Satisfaction of British Employees By Pouliakas, Konstantinos; Theodossiou, Ioannis
  15. Incentives to Innovate and Social Harm: Laissez-Faire, Authorization or Penalties? By Giovanni Immordino; Marco Pagano; Michele Polo
  16. The Architecture of Federations: Constitutions, Bargaining, and Moral Hazard By Kessler, Anke; Luelfesmann, Christoph; Myers, Gordon M

  1. By: Sunil Gupta; Carl F. Mela; Jose M. Vidal-Sanz
    Abstract: We study the problem of a firm that faces asymmetric information about the productivity of its potential workers. In our framework, a worker’s productivity is either assigned by nature at birth, or determined by an unobservable initial action of the worker that has persistent effects over time. We provide a characterization of the optimal dynamic compensation scheme that attracts only high productivity workers: consumption –regardless of time period– is ranked according to likelihood ratios of output histories, and the inverse of the marginal utility of consumption satisfies the martingale property derived in Rogerson (1985). However, in the case of i.i.d. output and square root utility we show that, contrary to the features of the optimal contract for a repeated moral hazard problem, the level and the variance of consumption are negatively correlated, due to the influence of early luck into future compensation. Moreover, in this example long-term inequality is lower under persistent private information
    Keywords: Customer lifetime value, CRM, Dynamic programming, GMM Estimation
    Date: 2009–03
  2. By: Zheng, Charles Zhoucheng
    Abstract: A game of competing principals is proposed. The set of subgame perfect equilibria of this game (subject to some refinement conditions) is equal to the core based on the same primitives. The blocking activity of a coalition of agents corresponds to a principal's unilateral deviation of proposing an off-path and incentive feasible contract. The equivalence between core and equilibrium is applied to cases of general equilibrium, Nash bargaining, moral hazard in polygamy, and adverse selection in auctions.
    Keywords: core, equilibrium, cooperative game theory, noncooperative game theory, coalition, polygamy
    JEL: C7
    Date: 2009–03–26
  3. By: Martin Gregor (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic); Dalibor Roháč (University of Oxford)
    Abstract: We extend a model of wasteful state aid in Dewatripont and Seabright (2006, Journal of the European Economic Association 4, 513--522) by a supranational controlling authority. The model combines moral hazard and adverse selection to show that politicians fund wasteful projects to signal their effort. Voters, unable to observe project benefits or effort, reward funding with a reelection premium that separates a high-effort politician from a low-effort politician. We examine state aid control by a benevolent authority which receives extra signals about the state of the world. We find that signals on the politician type are worthless. For signals on the project type, we derive a sufficient condition for aid control to unambiguously decrease welfare. We also prove that politicians do not respond to marginal changes in incentives. In this setup, the optimal state aid control is fairly often no control.
    Keywords: state aid, signaling, career concerns, aid control
    JEL: D72 D78 D82 H25
    Date: 2009–03
  4. By: Mallesh M. Pai; Rakesh Vohra
    Abstract: We consider an environment where potential buyers of an indi- visible good have liquidity constraints, in that they cannot pay more than their `budget' regardless of their valuation. A buyer's valuation for the good as well as her budget are her private information. We derive constrained-efficient and revenue maximizing auctions for this setting. In general, the optimal auction requires `pooling' both at the top and in the middle despite the maintained assumption of a mono- tone hazard rate. Further, the auctioneer will never¯find it desirable to subsidize bidders with low budgets.
    Keywords: the universal type space, the strategic topology; the uniform strategic topology; the uniform-weak topology; interim correlated rationalizable actions
    JEL: C70
    Date: 2008–08
  5. By: Simon Loertscher; Andras Niedermayer
    Abstract: Mechanisms where intermediaries charge a commission fee and have the sellers set the price are widely used in practice e.g. by real estate agents, stock brokers, art galleries, or auction houses. We model competition between intermediaries in a dynamic random matching model, where in every period a buyer, a seller, and an intermediary are randomly matched. In any period, every intermediary has a temporary monopoly and designs an exchange mechanism that maximizes his own expected profits. Traders’ valuations for the indivisible good depend on their option value of future trade. The following results obtain. First, we show that the intermediary can achieve the highest possible profit with a fee setting mechanism. Second, we characterize when these fees are linear. Third, fee setting is an equilibrium outcome in a dynamic market. Fourth, when the rematching probability increases or, equivalently, the period length decreases, the equilibrium fees become smaller. Our model is applicable to stock brokers and auction houses as intermediaries. It can further explain several of the stylized facts observed in real estate brokerage, such as the 6 percent fee, the relation between listing price and time on market, inefficient free entry, higher prices for houses owned by brokers, and home owners who bought during a boom asking higher prices. We also provide various extensions.
    Keywords: brokers, applied mechanism design, linear commission fees, optimal indirect mechanisms, internet auctions, auction houses.
    JEL: C72 C78 L13
    Date: 2008–11
  6. By: Kyle Bagwell
    Abstract: This paper considers self-enforcing trade agreements among privately informed governments. A trade agreement that uses weak bindings (i.e., maximal tariff levels) is shown to offer advantages relative to a trade agreement that uses strong bindings (i.e., precise tariff levels). Consistent with practice, the theory also predicts that governments sometimes apply tariffs that are strictly below their bound rates. When private information is persistent through time, an enforcement "ratchet effect" is identified: a government reveals that it is "weak," and thus that it is unlikely to retaliate in an effective manner, when it applies a low tariff. This effect suggests that a government with a low type may "pool" at an above-optimal tariff, in order to conceal weakness. It also suggests a new information-based theory of gradualism in trade agreements.
    JEL: D82 F13
    Date: 2009–03
  7. By: GAUTIER, Axel (UniversitŽ catholique de Louvain (UCL). Center for Operations Research and Econometrics (CORE)); YVRANDE-BILLON, Anne
    Abstract: In the French urban public transport industry, services are often delegated to a private firm by the mean of a fixed-term regulatory contract. This contract specifies the duties of the firm and a financial compensation. When it expires, a new contract is awarded, possibly to a different operator. Cost-plus and fixed-price (gross cost or net cost) contracts are commonly used to regulate the operators in the transport industry. In this paper, we analyse the incentives for the operator to reduce its cost. These incentives come from both the profit maximization during the current contract and the perspective of contract renewal. In our model, the amount of cost-reducing effort depends on the contract type and the time remaining till contract expiration. We use a sample of 124 French urban public transport networks covering the period 1995-2002 to test our predictions. Our proxy for the cost reducing effort is technical efficiency. The data largely confirm the importance of contract type on performances and the incentive effect of contract renewal.
    Keywords: incentive regulation, urban transport, stochastic frontier analysis.
    JEL: L33 L51 L92
    Date: 2008–12
  8. By: Menkhoff, Lukas; Schmeling, Maik
    Abstract: This paper shows how traders learn from post-trade identity disclosure in a currency limit order market. We establish that identity disclosure reveals information and show how traders react by reversing their order flow in line with the better informed. Informed traders primarily incorporate their own private as well as publicly available information into prices, whereas uninformed mainly magnify the effect of the informed. Within this framework, traders treat own and others? market orders as more informative than limit orders. We show that counterparty information drives out public information and that its value decays over time.
    Keywords: Identity disclosure, order flow, informed trading, foreign exchange
    JEL: G12 G15 D82 F31
    Date: 2009–03
  9. By: Christopher Cotton (Department of Economics, Cornell University)
    Abstract: A bidder may increase his bid over the course of an auction when (1) he becomes more certain about his private valuation over time (as he has more time to consider using the item), and (2) there is a positive probability he is unable to return to the auction to submit a bid in a later period. Evidence from a classroom experiment supports the theoretical findings.
    Keywords: auction, eBay, multiple bidding, value discovery
    JEL: D44 D82
    Date: 2008–05
  10. By: Eric Langlais
    Abstract: In this paper, we assume that a criminal organization is an agency where the Principal and the Agent have different sensibilities towards the risk of arrestation and punishment, and at the same time have different skills with respect to general organization tasks, crime realization or detection avoidance activities (i.e. allowing to reduce the probability of detection). In this set up, we first compare two regimes of exclusive sanctions (either the sanctions are borne by the Principal/beneficiary of the crime, or they are borne by the Agent/perpetrator of the crime), and we analyze the comparative efficiency of the various instruments which are at the disposal of public authorities to prevent corporation in criminal activities (frequency of control and level of monetary penalties). Finally, we study a case with joint liability.
    Keywords: Criminal teams, corporate criminality, state dependent risk aversion, deterrence, monetary penalties versus detection
    JEL: K13 K4
    Date: 2009
  11. By: Nikolaj Schmidt
    Abstract: Banks can enter new countries either through greenfield entry or by acquiring local banks. I model the effect of a foreign bank's mode of entry on the stability of the local financial sector. Banks exert costly effort when they extend credit. Limited liability creates an agency problem which leads to under provision of effort. I show that the diversification of the foreign bank.s loan portfolio mitigates the agency problem, and permits the foreign bank to extend credit during downturns where the local banks are forced to contract credit. The risk management framework employed by the foreign bank creates a divergence in the behaviour of a greenfield entrant and an acquirer. The greenfield entrant does not own a portfolio of local loans, and therefore, it has a greater risk taking capacity than the acquirer. Thus, competition, and thereby the distortion of the local banks' incentives to exert effort, is greater following greenfield entry than following entry through acquisition.
    Date: 2008–10
  12. By: Langlais, Eric
    Abstract: In this paper, we modelize a criminal organization as an agency where the Principal and the Agent have different sensibilities towards the risk of arrestation and punishment, and at the same time have different skills with respect to general organization tasks, crime realization or detection avoidance activities (i.e. allowing to reduce the probability of detection). In this set up, we first compare two regimes of exclusive sanctions (either the sanctions are borne by the Principal/beneficiary of the crime, or they are borne by the Agent/perpetrator of the crime), and we analyze the comparative efficiency of the various instruments which are at the disposal of public authorities to prevent corporation in criminal activities (frequency of control and level of monetary penalties). Finally, we study a case with joint liability.
    Keywords: Criminal teams; corporate criminality; state dependent risk aversion; deterrence; monetary penalties versus detection.
    JEL: K13 K42
    Date: 2008–11
  13. By: Braido, Luis (Fundacao Getulio Vargas); da Costa, Carlos (Fundacao Getulio Vargas); Dahlby, Bev (University of Alberta, Department of Economics)
    Abstract: We generalize the Boadway and Keen (2006) model of adverse selection in a capital market to allow for risk aversion on the part of entrepreneurs. We show that the Boadway and Keen conclusion-that adverse selection leads to excessive investment-does not necessarily hold when entrepreneurs are risk averse. We use their framework, with the additional assumption of risk aversion, to analyze the effect of policies that would reduce entrepreneurs' reliance on debt or equity financing by outside investors. We show that such policies, by exposing entrepreneurs to more down-side risk, may reduce the level of investment in risky projects, increase inequality and potentially reduce social welfare.
    Keywords: adverse selection; capital markets; inefficiency; risk and entrepreneurship
    JEL: D82 G14 O16 O17
    Date: 2009–03–16
  14. By: Pouliakas, Konstantinos; Theodossiou, Ioannis
    Abstract: The increasing use of incentive pay schemes in recent years has raised concerns about their potential detrimental effect on intrinsic job satisfaction (JS), job security and employee morale. This study explores the impact of pay incentives on the overall job satisfaction of workers in the UK and their satisfaction with various facets of jobs. Using data from eight waves (1998-2005) of the British Household Panel Survey (BHPS) and a uniquely-designed well-being dataset (EPICURUS), a significant positive impact on job satisfaction is only found for those receiving fixed-period bonuses. These conclusions are robust to unobserved heterogeneity, and are shown to depend on a number of job-quality characteristics that have not been controlled for in previous studies.
    Keywords: performance-related-pay; job satisfaction; job security; intrinsic satisfaction; sorting;
    JEL: J33 J28
    Date: 2009–03–03
  15. By: Giovanni Immordino (Università di Salerno and CSEF); Marco Pagano (Università di Napoli Federico II, CSEF, EIEF and CEPR); Michele Polo (Università Bocconi di Milano, IGIER and CSEF)
    Abstract: We analyze optimal policy design when firms' research activity may lead to socially harmful innovations. Public intervention, affecting the expected profitability of innovation, may both thwart the incentives to undertake research (average deterrence) and guide the use to which innovation is put (marginal deterrence). We show that public intervention should become increasingly stringent as the probability of social harm increases, switching first from laissez-faire to a penalty regime, then to a lenient authorization regime, and finally to a strict one. In contrast, absent innovative activity, regulation should rely only on authorizations, and laissez-faire is never optimal. Therefore, in innovative industries regulation should be softer.
    Keywords: innovation, liability for harm, safety regulation, authorization
    JEL: D73 K21 K42 L51
    Date: 2009–03–25
  16. By: Kessler, Anke; Luelfesmann, Christoph; Myers, Gordon M
    Abstract: The paper studies a federal system where a region provides non-contractible essential inputs for the successful implementation of a local public policy project with spill-overs, and where bargaining between different levels of government may ensure efficient decision making ex post. We ask whether the authority over the public policy measure should rest with the local government or with the central government, allowing financial relationships within the federation to be designed optimally. Centralization is shown to dominate when governments are benevolent. With regionally biased governments, both centralization and decentralization are suboptimal as long as political bargaining does not take place. With bargaining, however, the first best can often be achieved under decentralization, but not under centralization. At the root of this result is the alignment of decision making over essential inputs and project size under decentralized governance.
    Keywords: Constitutions; Decentralization; Federalism; Grants; Political Bargaining
    JEL: D23 D78 H21 H77
    Date: 2009–03

This nep-cta issue is ©2009 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.
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