nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2009‒12‒19
nineteen papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Contractual solutions to hold-up problems with quality uncertainty and unobservable investments By Schmitz, Patrick W.
  2. Dynamic Stackelberg Game with Risk-Averse Players: Optimal Risk-Sharing under Asymmetric Information By Dan Protopopescu
  3. A case for Ambiguity By Ascenci—n Andina-D’az
  4. Mutual guarantee institutions and small business finance By Francesco Columba; Leonardo Gambacorta; Paolo Emilio Mistrulli
  5. Information Variability Impacts in Auctions By Ronald M. Harstad; Michael H. Rothkopf; Justin Jia
  6. Delegated Portfolio Management and Risk Taking Behavior By José Luiz Barros Fernandes; Juan Ignacio Peña; Benjamin Miranda Tabak
  7. Negative agency costs By Jacques Thépot
  8. Testing for Adverse Selection in Insurance Markets By Alma Cohen; Peter Siegelman
  9. An Equilibrium Theory of Learning, Search and Wages By Francisco M. Gonzalez; Shouyong Shi
  10. Public versus Private Risk Sharing By Dirk Krueger; Fabrizio Perri
  11. The Law of Impersonal Transactions: Meaning and Difficulties By Benito Arruñada
  12. Winner's Curse Corrections Magnify Adverse Selection By Ronald M. Harstad; Robert Bordley
  13. Understanding the Plott-Wit-Yang Paradox By Katarina Kalovcova; Andreas Ortmann
  14. Controlling Banker's Bonuses: Efficient Regulation or Politics of Envy? By Matthews, Kent; Matthews, Owen
  15. Excessive Public Employment and Rent-Seeking Traps By Esteban Jaimovich; Juan Pablo Rud
  16. The Economics of Labor Coercion By Daron Acemoglu; Alexander Wolitzky
  17. Optimal Delegation with a Finite Number of States By Vincent Anesi; Daniel J. Seidmann
  18. Health Care Financing over the Life Cycle, Universal Medical Vouchers and Welfare By Juergen Jung; Chung Tran
  19. Does category reporting increase donations to charity? A signalling game approach. By Edward Cartwright; Amrish Patel

  1. By: Schmitz, Patrick W.
    Abstract: Consider a seller and a buyer who write a contract. After that, the seller produces a good. She can influence the expected quality of the good by making unobservable investments. Only the seller learns the realized quality. Finally, trade can occur. It is always ex post efficient to trade. Yet, it may be impossible to achieve the first best, even though the risk-neutral parties are symmetrically informed at the contracting stage and complete contracts can be written. The second best is characterized by distortions that are reminiscent of adverse selection models (i.e., models with precontractual private information but without hidden actions).
    Keywords: common values; hidden action; hidden information; hold-up problem
    JEL: D23 D82 D86
    Date: 2009–12
  2. By: Dan Protopopescu
    Abstract: The objective of this paper is to clarify the interactive nature of the leader-follower relationship when both players are endogenously risk-averse. The analysis is placed in the context of a dynamic closed-loop Stackelberg game with private information. The case of a risk-neutral leader, very often discussed in the literature, is only a borderline possibility in the present study. Each player in the game is characterized by a risk-averse type which is unknown to his opponent. The goal of the leader is to implement an optimal incentive compatible risk-sharing contract. The proposed approach provides a qualitative analysis of adaptive risk behavior profiles for asymmetrically informed players in the context of dynamic strategic interactions modelled as incentive Stackelberg games.
    Keywords: Dynamic stochastic Stackelberg game, optimal path, closed-loop control, endogenous risk-aversion, adaptive risk management, optimal risk-sharing.
    JEL: C71 C73 D81 D82
    Date: 2009–12–11
  3. By: Ascenci—n Andina-D’az (Department of Economic Theory, Universidad de M‡laga)
    Abstract: A sender wishes to be approved by a receiver, who is outcome concerned. She then has an incentive to send an informative message. But if there is more than one sender competing for the receiver's approval and the latter doubts about the objectives of senders, they each have an incentive to fool the receiver and look as the only truthful sender in the population. If they succeed, no truthful equilibrium exists. In this scenario, we show that it may be in the decision maker's interest to be ambiguous about his motives as, if prospering, he could guarantee revelation of information by (at least) outcome concerned senders.
    Keywords: Multiple experts, approval, two sided incomplete information
    JEL: D78 D82 D83
    Date: 2009–12
  4. By: Francesco Columba (Bank of Italy); Leonardo Gambacorta (Bank for International Settlements); Paolo Emilio Mistrulli (Bank of Italy JEL classification: D82, G21, G30, O16)
    Abstract: A large body of literature has shown that small firms experience difficulties in accessing the credit market due to informational asymmetries. Banks can overcome these asymmetries through relationship lending, or at least mitigate their effects by asking for collateral. Small firms, especially if they are young, have little collateral and short credit histories, and thus may find it difficult to raise funds from banks. In this paper, we show that even in this case, small firms may improve their borrowing capacity by joining Mutual Guarantee Institutions (MGI). Our empirical analysis shows that small firms affiliated to MGIs pay less for credit compared with similar firms. We obtain this result for interest rates charged on loan contracts which are not backed by mutual guarantees. We then argue that our findings are consistent with the view that MGIs are better at screening and monitoring opaque borrowers than banks are. Thus, banks benefit from the willingness of MGIs to post collateral since this implies that firms are better screened and monitored.
    Keywords: credit guarantee schemes, joint liability, microfinance, peer monitoring, small business finance
    Date: 2009–11
  5. By: Ronald M. Harstad (Department of Economics, University of Missouri-Columbia); Michael H. Rothkopf; Justin Jia
    Abstract: A wide variety of auction models exhibit close relationships between the winner's expected profit and the expected difference between the highest and second-highest order statistics of bidders' information, and between expected revenue and the second-highest order statistic of bidders' expected asset values. We use stochastic orderings to see when greater environmental variability of bidders' information enhances expected profit and expected revenue.
    Keywords: affiliated-values auctions, auction revenue, number of bidders, increased competition, endegenous bidder participation
    JEL: D44 D82 C72
    Date: 2009–06–15
  6. By: José Luiz Barros Fernandes; Juan Ignacio Peña; Benjamin Miranda Tabak
    Abstract: Standard models of moral hazard predict a negative relationship between risk and incentives; however empirical studies on mutual funds present mixed results. In this paper, we propose a behavioral principal-agent model in the context of professional managers, focusing on active and passive investment strategies. Using this general framework, we evaluate how incentives affect the risk taking behavior of managers, using the standard moral hazard model as a special case; and solve the previous contradiction. Empirical evidence, based on a comprehensive world sample of 4584 mutual funds, gives support to our theoretical model.
    Date: 2009–12
  7. By: Jacques Thépot (Laboratoire de Recherche en Gestion et Economie, Université de Strasbourg)
    Abstract: Managerial opportunism is commonly considered as destructive for the parties involved in an agency relationship. Using a close formulation to Jensen and Meckling’s equity model, we consider an agency relationship between a manager and an investor. The latter is assumed to benefit from a market power through external funding opportunities. For high values of the prevailing rate of interest, we prove that the agency costs can be negative, either when the manager or the investor acts as the leader in the agency relation. These results suggest that external conditions may have a differentiated impact on the ex ante and ex post inefficiencies created by managerial opportunism.
    Keywords: Corporate finance, agency cost, market power.
    JEL: G3
    Date: 2009
  8. By: Alma Cohen; Peter Siegelman
    Abstract: This paper reviews and evaluates the empirical literature on adverse selection in insurance markets. We focus on empirical work that seeks to test the basic coverage–risk prediction of adverse selection theory—that is, that policyholders who purchase more insurance coverage tend to be riskier. The analysis of this body of work, we argue, indicates that whether such a correlation exists varies across insurance markets and pools of insurance policies. We discuss various reasons why a coverage–risk correlation may be found in some pools of insurance policies but not in others. We also review the work on the disentangling of adverse selection and moral hazard and on learning by policyholders and insurers.
    JEL: D82 G22
    Date: 2009–12
  9. By: Francisco M. Gonzalez; Shouyong Shi
    Abstract: We examine the labor market effects of incomplete information about the workers' own job-finding process. Search outcomes convey valuable information, and learning from search generates endogenous heterogeneity in workers' beliefs about their job-finding probability. We characterize this process and analyze its interactions with job creation and wage determination. Our theory sheds new light on how unemployment can affect workers' labor market outcomes and wage determination, providing a rational explanation for discouragement as the consequence of negative search outcomes. In particular, longer unemployment durations are likely to be followed by lower re-employment wages because a worker's beliefs about his job-finding process deteriorate with unemployment duration. Moreover, our analysis provides a set of useful results on dynamic programming with optimal learning.
    Keywords: Learning; Wages; Unemployment; Directed search; Monotone comparative statics
    JEL: E24 D83 J64
    Date: 2009–12–08
  10. By: Dirk Krueger; Fabrizio Perri
    Abstract: Can public insurance through redistributive income taxation improve the allocation of risk in an economy in which private risk sharing is limited? The answer depends crucially on the fundamental friction that limits private risk sharing in the first place. If risk sharing is incomplete because some insurance markets are missing for model-exogenous reasons (as in Bewley, 1986 and Aiyagari, 1994) publicly provided risk sharing via a tax system generally improves on the allocation of risk. If instead private insurance markets exist but their use is limited by the absence of complete enforcement (as in Kehoe and Levine, 1993 and Kocherlakota, 1996) then the provision of public insurance can crowd out private insurance to such an extent that total consumption insurance is reduced. By reducing income risk the tax system increases the value of being excluded from private insurance markets and hence weakens the enforcement mechanism of these contracts. In this paper we theoretically characterize and numerically compute equilibria in an economy with limited enforcement and a continuum of agents facing realistic income risk and tax systems with various degrees of risk reduction (progressivity). We find that the crowding-out effect of public insurance on private insurance in the limited enforcement model can be quantitatively important, as is the positive insurance effect of taxation in the Bewley model.
    JEL: D52 E62 H31
    Date: 2009–12
  11. By: Benito Arruñada
    Abstract: Most economic interactions happen in a context of sequential exchange in which innocent third parties suffer information asymmetry with respect to previous “originative” contracts. The law reduces transaction costs by protecting these third parties but preserves some element of consent by property right holders to avoid damaging property enforcement—e.g., it is they as principals who authorize agents in originative contracts. Judicial verifiability of these originative contracts is obtained either as an automatic byproduct of transactions or, when these would have remained private, by requiring them to be made public. Protecting third parties produces a sort of legal commodity which is easy to trade impersonally, improving the allocation and specialization of resources. Historical delay in generalizing this legal commoditization paradigm is attributed to path dependency—the law first developed for personal trade—and an unbalance in vested interests, as luddite legal professionals face weak public bureaucracies.
    Keywords: Property rights, formalization, impersonal transactions.
    JEL: O17 K22 K23 L59
    Date: 2009–11
  12. By: Ronald M. Harstad (Department of Economics, University of Missouri-Columbia); Robert Bordley
    Abstract: The adverse-selection literature has only considered the case in which competing sellers' costs of supply are independent and privately known by the individual sellers. In contrast, the auction literature has ignored adverse selection by implicitly assuming that a bid-taker is indifferent between suppliers at a given price. We show that competition in auctions with common-value elements serves to magnify the impact of adverse selection, as a bidder supplying a higher-cost product rationally makes a heightened winner's curse correction in a procurement auction. Hence lower-cost suppliers are disproportionately likely to win the auction, potentially creating a more serious quality problem for the procurer than mainstream adverse-selection models suggest.
    Keywords: winner's curse; adverse selection; common-value auctions; procurement; product quality
    JEL: D44 D82 L14 C62
    Date: 2009–06–15
  13. By: Katarina Kalovcova; Andreas Ortmann
    Abstract: Plott, Wit & Yang (2003) conduct a betting market experiment and nd: First, information was aggregated. This suggests that traders updated their private information based on observed market odds. Second, a model based only on the use of private information seems to fit their data best. The authors call this paradoxical. Because the original data are lost, we replicate their experiment. Our results suggest that the paradox seems due to aggregate rather than individual level data analysis. We analyze the individual level data and explain the paradoxical results reported in Plott et al. (2003).
    Keywords: Experimental betting markets, private information, information aggregation.
    JEL: D81 D82 G14
    Date: 2009–11
  14. By: Matthews, Kent (Cardiff Business School); Matthews, Owen
    Abstract: The positive relationship between bank CEO compensation and risk taking is a well established empirical fact. The global banking crisis has resulted in a chorus of demands to control banker's bonuses and thereby curtail their risk taking activities in the hope that the world can avoid a repeat in the future. However, the positive relationship is not a causative one. In this paper we argue that the cushioning of banks downside risks provide the incentive for banks to take excessive risk and design compensation packages to deliver high returns. Macro-prudential regulation will have a better chance of curbing excess risk taking than controlling banker's compensation.
    Keywords: Banker's bonus; risk taking; Too-big-to-Fail; macro-prudential regulation
    JEL: G21 G28
    Date: 2009–12
  15. By: Esteban Jaimovich; Juan Pablo Rud
    Abstract: We propose an occupational choice model in which the quality of the state bureaucracy influences aggregate output and the level of entrepreneurial activity through its participation in the labour market. Skilled agents differ in terms of their public service motivation: if agents with low public mission become bureaucrats, they will use their position to rent seek, by employing an excessive number of unskilled workers. This generates an upwards pressure on wages, which lowers profits and deters entrepreneurship. A better equilibrium results when public service motivated agents self-select into the state bureaucracy, since they exert high effort and employ a limited number of workers. The model also shows that the working class might optimally choose to vote for an inefficient public sector. We provide evidence supporting the mechanism in our model by confronting some of its main predictions to a variety of data sources.
    Keywords: Occupational Choice, Public Service Motivation, Political Economy
    JEL: O10 J24 H11 H83
    Date: 2009
  16. By: Daron Acemoglu; Alexander Wolitzky
    Abstract: The majority of labor transactions throughout much of history and a significant fraction of such transactions in many developing countries today are "coercive", in the sense that force or the threat of force plays a central role in convincing workers to accept employment or its terms. We propose a tractable principal-agent model of coercion, based on the idea that coercive activities by employers, or "guns", affect the participation constraint of workers. We show that coercion and effort are complements, so that coercion increases effort. Nevertheless, coercion is always "inefficient", in the sense of reducing utilitarian social welfare. Better outside options for workers reduce coercion, because of the complementarity between coercion and effort: workers with better outside option exert lower effort in equilibrium and thus are coerced less. Greater demand for labor increases coercion because it increases equilibrium effort. We investigate the interaction between outside options, market prices, and other economic variables by embedding the (coercive) principal-agent relationship in a general equilibrium setup, and study when and how labor scarcity encourages coercion. We show that general (market) equilibrium interactions working through prices lead to a positive relationship between labor scarcity and coercion along the lines of ideas suggested by Domar, while those working through outside options lead to a negative relationship similar to ideas advanced in neo-Malthusian historical analyses of the decline of feudalism. A third effect, which is present when investment in guns must be made before the realization of contracting opportunities, also leads to a negative relationship between labor scarcity and coercion. Our model also predicts that coercion is more viable in industries that do not require relationship-specific investment by workers.
    JEL: D23 D74 D86 J01 P16
    Date: 2009–12
  17. By: Vincent Anesi (University of Nottingham); Daniel J. Seidmann (University of Nottingham)
    Abstract: This paper contributes to the literature on optimal delegation, dating back to Holmstrom's (1984) seminal work. In contrast to models in the Holmstrom tradition, we assume that the set of states is finite. We provide a full characterization of the class of optimal delegation sets under this assumption, and show that they have a different structure from that in the continuous-state model. As the number of states tends to infinity, however, every optimal delegation set converges to that of Holmstrom (1984). We also show that, for intermediate bias, the Ally Principal fails for small changes in bias, the Uncertainty Principle may fail, and the principal prefers to appoint an amateur agent.
    Keywords: Optimal delegation, finite states, Ally Principle, Uncertainty Principle, expertise
    Date: 2009–11
  18. By: Juergen Jung (Department of Economics, Towson University); Chung Tran (School of Economics, University of New South Wales)
    Abstract: In this paper we develop a general equilibrium overlapping generations (OLG) model with health shocks to analyze the life-cycle pattern of insurance choice and health care spending. We use data from the Medical Expenditure Panel Survey (MEPS) and show that our model is able to match the life-cycle trends of insurance take up ratios and average medical expenditures in the U.S. We then demonstrate how this model can be used to conduct health care policy analysis by evaluating the macroeconomic effects of a counter factual health care reform using a system of universal health insurance vouchers. Our results suggest that health insurance vouchers are able to extend insurance coverage to the entire population but they also increase aggregate spending on health. More importantly, we find that the positive insurance effect (efficient risk pooling) dominates the negative incentive effect (tax distortions and moral hazard) which results in significant welfare gains for all generations when a payroll tax is used to finance the voucher program. In addition, our results suggest that the choice of tax financing instrument and accounting for general equilibrium price adjustments are critical in determining the performance of the voucher program.
    Keywords: Public health insurance; private health insurance; vouchers; dynamic stochastic general equilibrium model; endogenous health production
    JEL: H51 I18 I38
    Date: 2009–11
  19. By: Edward Cartwright; Amrish Patel
    Abstract: Many charities report donations using categories. We question whether such category reporting increases donations in a signalling game where a donor is either generous or not generous. Conditions are derived under which category reporting will increase giving or decrease giving. Category reporting will increase giving if the probability a donor is generous is low and/or donor preferences depend a lot on type.
    Keywords: Public good; charity; category reporting; signalling.
    JEL: C72 H41
    Date: 2009–12

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