nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2009‒11‒21
seventeen papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Mutual Loan-Guarantee Societies in Monopolistic Credit Markets with Adverse Selection By Giovanni Busetta; Alberto Zazzaro
  2. Impact of Genetic Testing on Surveillance and Prevention By Lilia Filipova; Michael Hoy
  3. Decentralized Trading with Private Information By Mikhail Golosov; Guido Lorenzoni; Aleh Tsyvinski
  4. Implementability of Correlated and Communication Equilibrium Outcomes in Incomplete Information Games By Igal Milchtaich
  5. Information Advantage in Cournot Oligopoly with Separable Information, or Nondifferentiable By Haimanko, Ori
  6. Efficient Repeated Implementation By Lee, J.; Sabourian, H.
  7. Sweet Talk: A Theory of Persuasion By Di Maggio, Marco
  8. Third-Party Intervention in Conflicts and the Indirect Samaritan’s Dilemma By J. Atsu Amegashie
  9. Optimal investment with inside information and parameter uncertainty By Albina Danilova; Michael Monoyios; Andrew Ng
  10. Pay for percentile By Gadi Barlevy; Derek Neal
  11. Eects of Court Errors on EÆciency of Liability Rules: When Individuals are Imperfectly Informed By Ram Singh
  12. Securitization and moral hazard: evidence from a lender cutoff rule By Ryan Bubb; Alex Kaufman
  13. Sorting, reputation and entry in a market for experts By Enrico Sette
  15. Internal capital markets and corporate politics in a banking group By Martijn Cremers; Rocco Huang; Zacharias Sautner
  16. Accountability and Cheap Talk By Di Maggio, Marco
  17. Simple Mediation in a Cheap-Talk Game By Chirantan Ganguly; Indrajit Ray

  1. By: Giovanni Busetta (Universit… di Messina, Department of Economics, Statistics, Mathematics, and Sociology V. Pareto); Alberto Zazzaro (Universit… Politecnica delle Marche, Department of Economics, MoFiR)
    Abstract: In many countries, Mutual Loan-Guarantee Societies (MLGSs) are assuming ever-increasing importance for small business lending. In this paper we provide a theory to rationalise the raison d'^etre of MLGSs. The basic intuition is that the foundation for MLGSs lies in the inefficiencies created by adverse selection, when borrowers do not have enough collateralisable wealth to satisfy collateral requirements and induce self-selecting contracts. In this setting, we view MLGSs as a wealth-pooling mechanism that allows otherwise inefficiently rationed borrowers to obtain credit. We focus on the case of large, complex urban economies where potential entrepreneurs are numerous and possess no more information about each other than do banks. Despite our extreme assumption on information availability, we show that MLGSs can be characterized by assortative matching in which only safe borrowers have an incentive to join the mutual society.
    Keywords: Collateral, Group formation, Mutual Loan Guarantee Society, Small business lending
    JEL: D82 G21
    Date: 2009–11
  2. By: Lilia Filipova (University of Augsburg); Michael Hoy (Department of Economics, University of Guelph)
    Abstract: There is a prospect of substantial advancements in the understanding of the relationship between disease and genetics at least in the medium term to long term future. In this paper we consider the implications on two aspects of behaviour - surveillance to improve the chances of early detection of disease onset and preventive actions to reduce the probability of onset - that may change as a result of the acquisition of information from genetic tests. We argue that there are problems for both private insurance regimes, with risk-rating allowed according to genetic type, and public insurance regimes (or a private insurance system with an "effective" community rating regulation) in generating potential health benefits from increased genetic information. In the public regime appropriate signals to obtain genetic information are not always provided while in the private regime premium risk can block otherwise fruitful acquisitions of this information. In both regimes moral hazard considerations can blunt the adoption of otherwise useful information with the further problem for public insurance of possibly encouraging excessive adoption of genetic testing.
    Keywords: value of information, surveillance, prevention.
    Date: 2009
  3. By: Mikhail Golosov; Guido Lorenzoni; Aleh Tsyvinski
    Abstract: The paper studies asset pricing in informationally decentralized markets. These markets have two key frictions: trading is decentralized (bilateral), and some agents have private information. We analyze how uninformed agents acquire information over time from their bilateral trades. In particular, we show that uninformed agents can learn all the useful information in the long run and that the long-run allocation is Pareto efficient. We then explore how informed agents can exploit their informational advantage in the short run and provide sufficient conditions for the value of information to be positive. Finally, we provide a numerical analysis of the equilibrium trading dynamics and prices.
    JEL: D82 D84 G12 G14
    Date: 2009–11
  4. By: Igal Milchtaich (Department of Economics, Bar-Ilan University)
    Abstract: In a correlated equilibrium, the players’ choice of actions is affected by random, correlated messages that they receive from an outside source, or mechanism. This allows for more equilibrium outcomes than without such messages (pure-strategy equilibrium) or with statistically independent ones (mixed-strategy equilibrium). In an incomplete information game, the messages may also convey information about the types of the other players, either because they reflect extraneous events that affect the types (correlated equilibrium) or because the players themselves report their types to the mechanism (communication equilibrium). Thus, mechanisms can be classified by the connections between the messages that the players receive and their own and the other players’ types, the dependence or independence of the messages, and whether randomness is involved. These properties may affect the achievable equilibrium outcomes, i.e., the payoffs and joint distributions of type and action profiles. Whereas for complete information games there are only three classes of equilibrium outcomes, with incomplete information the number is 14–15 for correlated equilibria and 15–17 for communication equilibria. Each class is characterized by the properties of the mechanisms that implement its members. The majority of these classes have not been described before.
    Keywords: Correlated equilibrium, Communication equilibrium, Incomplete information, Bayesian games, Mechanism, Correlation device, Implementation
    Date: 2009–11
  5. By: Haimanko, Ori
    Abstract: Einy et al (2002) showed that information advantage of a firm is rewarded in any equilibrium of an incomplete information Cournot oligopoly, provided the inverse demand function is differentiable and monotonically decreasing, and costs are affine. We extend this result in two directions. We show first that a firm receives not less than its rival even if that firm's information advantage is only regarding payoff-relevant data, and not necessarily payoff-irrelevant "sunspots". We then show that there is at least one equilibrium which rewards firm's information advantage even with non-differentiable, but concave, inverse demand function. Under certain conditions, these results hold even with always non-negative inverse demand functions.
    Keywords: Oligopoly, Incomplete Information, Information advantage, Bayesian Cournot, Equilibrium, Sunspots, Non-differentiability, Inverse demand
    JEL: C72 D43 L13
    Date: 2009–09
  6. By: Lee, J.; Sabourian, H.
    Abstract: This paper examines repeated implementation of a social choice function (SCF) with infinitely-lived agents whose preferences are determined randomly in each period. An SCF is repeated-implementable in (Bayesian) Nash equilibrium if there exists a sequence of (possibly history-dependent) mechanisms such that (i) its equilibrium set is non-empty and (ii) every equilibrium outcome corresponds to the desired social choice at every possible history of past play and realizations of uncer- tainty. We first show, with minor qualifications, that in the complete information environment an SCF is repeated-implementable if and only if it is effcient. We then extend this result to the incomplete information setup. In particular, it is shown that in this case efficiency is sufficient to ensure the characterization part of repeated implementation. For the existence part, incentive compatibility is sufficient but not necessary. In the case of interdependent values, existence can also be established with an intuitive condition stipulating that deviations can be detected by at least one agent other than the deviator. Our incomplete information analysis can be extended to incorporate the notion of ex post equilibrium.
    Keywords: Repeated implementation, Nash implementation, Bayesian implementation, Ex post implementation, Efficiency, Incentive compatibility, Identifiability
    JEL: A13 C72 C73 D78
    Date: 2009–11–13
  7. By: Di Maggio, Marco
    Abstract: This paper introduces a model of sweet talk in which a seller may acquire verifiable information and selectively disclose it to a buyer to negotiate a deal. We start by analyzing a model with common priors in which the seller generates information for two reasons: a trading motive and a profit motive that is, to make trade possible or to increase the gains from it. There exists a negotiation region in which the seller continues to reveal information even if trading is already profitable. We extend the model, allowing for different prior beliefs about the value of the object, arguing that a complementarity between the seller's confidence and the precision of his information endogenously arises. Appointing an optimistic salesman may be costly because he may destroy profitable trading opportunities. We also allow the seller to choose in which market to trade: a matching market with a fixed price or a haggling market. Our model also provides a testable difference between a model of trading with homogenous priors and one with heterogeneous priors and finds application in understanding contracts as reference points.
    Keywords: persuasion games; haggling; negotiation; bargaining; heterogeneous priors; overconfidence; consummate and perfunctory performance; verifiable information.
    JEL: D86 C78 D82 D83
    Date: 2009–11–15
  8. By: J. Atsu Amegashie (Department of Economics,University of Guelph)
    Abstract: I study a two-period model of conflict with two combatants and a third party who is an ally of one of the combatants. The third party is fully informed about the type of her ally but not about the type of her ally’s enemy. There is a signaling game between the third party and her ally’s enemy where preferences do not satisfy the single-crossing condition. There exist perfect Bayesian equilibria in which the third party’s intervention worsens the conflict by energizing her ally’s enemy wherein he (i.e., the enemy) pretends to be stronger than he actually is in order to discourage the third-party from assisting her ally. This creates a dilemma for the third party which may be referred to as the indirect Samaritan’s dilemma. I find that the expectation of a third-party’s military assistance to an ally coupled with the third-party’s limited information about the strength of her ally’s enemy can be strategically exploited by the enemy through pronouncements that would not have been credible if the third party was fully informed about her ally’s enemy. Remarkably, the third-party’s ally, who is fully informed about the enemy, is unable to counteract this behavior by using credible signals to reveal his information to the third party. In some cases, the third party and her ally are strictly better off if the third-party’s decision to withdraw from or stay in the conflict is based on her prior beliefs and not on the current conditions of the conflict even if observing the current conditions improves the third-party’s information. Unlike the standard Samaritan’s dilemma, a commitment by the third party to a given level of assistance may be welfare-improving.
    Keywords: Bayesian equilibrium, Grossman-Perry refinement, conflict, intuitive criterion, Samaritan’s dilemma.
    JEL: D72 D74
    Date: 2009
  9. By: Albina Danilova; Michael Monoyios; Andrew Ng
    Abstract: An optimal investment problem is solved for an insider who has access to noisy information related to a future stock price, but who does not know the stock price drift. The drift is filtered from a combination of price observations and the privileged information, fusing a partial information scenario with enlargement of filtration techniques. We apply a variant of the Kalman-Bucy filter to infer a signal, given a combination of an observation process and some additional information. This converts the combined partial and inside information model to a full information model, and the associated investment problem for HARA utility is explicitly solved via duality methods. We consider the cases in which the agent has information on the terminal value of the Brownian motion driving the stock, and on the terminal stock price itself. Comparisons are drawn with the classical partial information case without insider knowledge. The parameter uncertainty results in stock price inside information being more valuable than Brownian information, and perfect knowledge of the future stock price leads to infinite additional utility. This is in contrast to the conventional case in which the stock drift is assumed known, in which perfect information of any kind leads to unbounded additional utility, since stock price information is then indistinguishable from Brownian information.
    Date: 2009–11
  10. By: Gadi Barlevy; Derek Neal
    Abstract: We propose an incentive pay scheme for educators that links educator compensation to the ranks of their students within appropriately defined comparison sets, and we show that under certain conditions our scheme induces teachers to allocate socially optimal levels of effort to all students. Because this scheme employs only ordinal information, our scheme allows education authorities to employ completely new assessments at each testing date without ever having to equate various assessment forms. This approach removes incentives for teachers to teach to a particular assessment form and eliminates opportunities to influence reward pay by corrupting the equating process or the scales used to report assessment results. Our system links compensation to the outcomes of properly seeded contests rather than cardinal measures of achievement growth. Thus, education authorities can employ our incentive scheme for educators while employing a separate system for measuring growth in student achievement that involves no stakes for educators. This approach does not create direct incentives for educators to take actions that contaminate the measurement of student progress.
    Date: 2009
  11. By: Ram Singh
    Abstract: The aim of this paper is to study the effects of court errors in estimating the harm, on the parties' behaviour regarding the levels of care they take, and their decision to buy the information about the court errors. The analysis is carried out in a unified framework. [CDE-DSE WP no. 97].
    Keywords: information, victim, liability paymentsocial costs, court errors, decision,
    Date: 2009
  12. By: Ryan Bubb; Alex Kaufman
    Abstract: Credit score cutoff rules result in very similar potential borrowers being treated differently by mortgage lenders. Recent research has used variation induced by these rules to investigate the connection between securitization and lender moral hazard in the recent financial crisis. However, the conclusions of such research depend crucially on understanding the origin of these cutoff rules. We offer an equilibrium model in which cutoff rules are a rational response of lenders to per-applicant fixed costs in screening. We then demonstrate that our theory fits the data better than the main alternative theory already in the literature, which supposes cutoff rules are exogenously used by securitizers. Furthermore, we use our theory to interpret the cutoff rule evidence and conclude that mortgage securitizers were in fact aware of and attempted to mitigate the moral hazard problem posed by securitization.
    Keywords: Mortgage-backed securities ; Mortgage loans ; Credit scoring systems
    Date: 2009
  13. By: Enrico Sette (Bank of Italy)
    Abstract: This paper analyses the market for professional (expert) services where the experts are motivated by reputational concerns. A key feature of such markets, which is often overlooked, is that clients can have specific characteristics that affect their evaluation of the service, and (or) the likelihood the service can be provided successfully. These different characteristics can induce clients to choose between experts with different reputations. The paper shows that clients choices have an important impact on the incentives of experts to provide a high quality service. In particular, sorting of clients affects incentives through three channels: changes in the types of client who are indifferent between getting the service from experts of different reputation, changes in the information on good performance as a signal of an expert's talent, and changes in the average complexity of the service the expert provides which impacts on the marginal efficiency of effort. The paper also investigates under what conditions increased entry of experts increases their incentives to exert effort. The results of the model can be applied to examine the effects of entry into the markets for doctors, lawyers, professional consultancies.
    Keywords: reputation, competition, sorting, experts, entry
    JEL: D82 L15 L84
    Date: 2009–08
  14. By: Maria De Paola; Valeria Pupo; Vincenzo Scoppa (Dipartimento di Economia e Statistica, Università della Calabria)
    Abstract: In this paper we analyse how the absence behaviour of Italian public sector employees has been affected by a law, passed in June 2008, reducing sick leave compensation and increasing monitoring intensity. We use micro-data on a sample of about 860 workers, employed at an Italian public administration, for years going from 2005 to 2009. We estimate the effect of the reform using linear and non-linear estimators. As predicted by agency theory, individuals react to economic incentives: the employees in our sample have considerably reduced their absences under the new regime. Since the reform has affected employees in a non uniform way, we show that the reduction of absenteeism is significantly stronger for employees suffering higher earning losses. Results also show that while the reform has reduced the duration of short absence spells, the duration of long spells has increased. We argue that this is due to the non-linearity of earning losses introduced by the new law.
    Keywords: Worker Absenteeism, Moral Hazard, Shirking, Sickness, Insurance Contracts
    JEL: J41 J45 M52 D86 C20
    Date: 2009–10
  15. By: Martijn Cremers; Rocco Huang; Zacharias Sautner
    Abstract: This study looks inside a large retail-banking group to understand how influence within the group affects internal capital allocations and lending behavior at the member bank level. The group consists of 181 member banks that jointly own a headquarters. Influence is measured by the divergence from one-share-one-vote. The authors find that more influential member banks are allocated more capital from headquarters. They are less likely to decrease lending after negative deposit growth or to increase lending following positive deposit growth. These effects are stronger in situations in which information asymmetry between banks and the headquarters seems greater. The evidence suggests that influence can be useful in overcoming information asymmetry.
    Keywords: Banks and banking ; Corporate governance
    Date: 2009
  16. By: Di Maggio, Marco
    Abstract: This paper analyzes a cheap talk model with heterogeneous receivers who are accountable for the correctness of their actions, showing that there exists a truth-revealing equilibrium. This sheds new light on the important role played by elections in shaping politicians' and, more surprisingly, advisor's behaviors in a cheap-talk setting. In deciding which message to send, the advisor is aware that he could use this message to affect the electoral outcome, the manipulation effect, or to shape the first period policy, the influence effect. When the first effect dominates the second there exists an informative equilibrium. In addition, I show that the presence of heterogeneous politicians leads to an increase in voters' welfare as a result of better-informed decisions. I allow the politician to delegate authority to the expert, showing that due to the signaling value of the politician's delegation decision, only corrupt or incompetent incumbents will delegate the second-period decision. Finally, I generalize the results in a number of different directions.
    Keywords: cheap talk; corruption; reputation; ideology.
    JEL: D73 D83 D82
    Date: 2009–11–15
  17. By: Chirantan Ganguly; Indrajit Ray
    Abstract: In the Crawford-Sobel (uniform, quadratic utility) cheap-talk model, we consider a simple mediation scheme (a communication device) in which the informed agent reports one of N possible elements of a partition to the mediator and then the mediator suggests one of N actions to the uninformed decision-maker according to the probability distribution of the device. We show that such a simple mediated equilibrium cannot improve upon the unmediated N-partition Crawford-Sobel equilibrium when the preference divergence parameter (bias) is small.
    Keywords: Cheap Talk, Mediated Equilibrium; Cheap Talk, Mediated Equilibrium
    JEL: C72
    Date: 2009–11

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