nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2010‒03‒13
fifteen papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Optimal Interventions in Markets with Adverse Selection By Thomas Philippon; Vasiliki Skreta
  2. Renegotiation-proof Mechanism Design By Zvika Neeman; Gregory Pavlov
  3. Innovation Contests with Entry Auction By Thomas Giebe
  4. Large Risks, Limited Liability, and Dynamic Moral Hazard. By Biais, Bruno; Mariotti, Thomas; Rochet, Jean-Charles; Villeneuve, Stéphane
  5. Matching Firms, Managers, and Incentives By Oriana Bandiera; Luigi Guiso; Andrea Prat; Raffaella Sadun
  6. Self-fulfilling liquidity dry-ups By Frédéric Malherbe
  7. Truth and Envy in Capacitated Allocation Games By Edith Cohen; Michal Feldman; Amos Fiat; Haim Kaplan; Svetlana Olonetsky
  8. Integration and Information: Markets and Hierarchies Revisited By Robert S. Gibbons; Richard T. Holden; Michael L. Powell
  9. Democratic Errors By Christopher J. Ellis; John Fender
  10. Rational-Expectations Equilibrium in Intermediate Good Markets By Robert S. Gibbons; Richard T. Holden; Michael L. Powell
  11. Reciprocity in Teams: a Behavioral Explanation for Unpaid Overtime By Natalia
  12. Enhancing Bank Transparency: What Role for the Supervision Authority? By Francesco Giuli; Marco Manzo
  13. Optimal market design By Jan Boone; Jacob K. Goeree
  14. Committing to Incentives: Should the Decision to Sanction be Revealed or Hidden? By Charlotte Klempt; Kerstin Pull
  15. Strategyproof Approximation Mechanisms for Location on Networks By Noga Alon; Michal Feldman; Ariel D. Procaccia; Moshe Tennenholtz

  1. By: Thomas Philippon; Vasiliki Skreta
    Abstract: We study interventions to restore efficient lending and investment when financial markets fail because of adverse selection. We solve a design problem where the decision to participate in a program offered by the government can be a signal for private information. We characterize optimal mechanisms and analyze specific programs often used during banking crises. We show that programs attracting all banks dominate those attracting only troubled banks, and that simple guarantees for new debt issuances implement the optimal mechanism, while equity injections and asset buyback do not. We also discuss the consequences of moral hazard.
    JEL: D02 D62 D82 D86 E44 E58 G2
    Date: 2010–02
  2. By: Zvika Neeman (Tel-Aviv University); Gregory Pavlov (University of Western Ontario)
    Abstract: We study a mechanism design problem under the assumption that renegotiation cannot be prevented. We investigate what kind of equilibria of which mechanisms are renegotiation-proof under a variety of renegotiation procedures, and which social choice functions can be implemented in a way that is renegotiation-proof. In complete information environments, we show that the set of ex post renegotiation-proof implementable social choice functions contains all ex post efficient allocations when there at least three agents, but only budget balanced Groves allocations when there are two agents. In incomplete information environments with correlated beliefs and at least three agents, every ex post efficient social choice function can be implemented in the presence of ex post renegotiation, but with independent private values only social choice functions that are given by budget balanced “Groves in expectations” mechanisms are implementable in such a way. We further show that the requirement of interim renegotiation-proofness does not impose additional restrictions on implementable social choice functions under complete information, but is likely to impose additional restrictions under incomplete information.
    Keywords: Mechanism design; Implementation; Ex post renegotiation; Interim renegotiation
    JEL: D02 D70 D82 D86
    Date: 2010
  3. By: Thomas Giebe (Humboldt University at Berlin)
    Abstract: We consider procurement of an innovation fromheterogeneous sellers. Innovations are random but depend on unobservable effort and private information. We compare two procurement mechanisms where potential sellers first bid in an auction for admission to an innovation contest. After the contest, an innovation is procured employing either a fixed prize or a first–price auction. We characterize Bayesian Nash equilibria such that both mechanisms are payoff–equivalent and induce the same efforts and innovations. In these equilibria, signaling in the entry auction does not occur since contestants play a simple strategy that does not depend on rivals’ private information.
    Keywords: Contest, Auction, Innovation, Research, R&D, Procurement, Signaling
    JEL: D21 D44 D82 H57 O31 O32
    Date: 2010–02
  4. By: Biais, Bruno; Mariotti, Thomas; Rochet, Jean-Charles; Villeneuve, Stéphane
    JEL: C61 D82 D86 D92
    Date: 2010–01
  5. By: Oriana Bandiera (London School of Economics); Luigi Guiso (European University Institute); Andrea Prat (London School of Economics); Raffaella Sadun (Harvard Business School, Strategy Unit; London School of Economics - Centre for Economic Performance)
    Abstract: We provide evidence on the match between firms, managers, and incentives using a new survey that contains information on managers’ risk preferences and human capital, on their compensation schemes, and on the firms they work for. The data is consistent with the equilibrium correlations predicted by a model where firms with di¤erent owner-ship structure and managers with different risk aversion and talent match endogenously through incentive contracts. The model predicts and the data support that, compared to widely-held firms, family firms use contracts that are less sensitive to performance; these contracts attract less talented and more risk averse managers; these managers work less hard, earn less, and display lower job satisfaction.
    Date: 2010–02
  6. By: Frédéric Malherbe (National Bank of Belgium, Research Department; Université Libre de Bruxelles, ECARES)
    Abstract: Secondary markets for long-term assets might be illiquid due to adverse selection. In a model in which moral hazard is confined to project initiation, I find that: (1) when agents expect a liquidity dry-up on such markets, they optimally choose to self-insure through the hoarding of non-productive but liquid assets; (2) such a response has negative externalities as it reduces ex-post market participation, which worsens adverse selection and dries up market liquidity; (3) liquidity dry-ups are Pareto inefficient equilibria; (4) the Government can rule them out. Additionally, when agents face idiosyncratic, privately known, illiquidity shocks, I show that: (5) it increases market liquidity; (6) illiquid agents are better-off when they can credibly disclose their liquidity position, but transparency has an ambiguous effect on risk-sharing possibilities.
    Keywords: Liquidity, Liquidity Dry-ups, Financial Crises, Hoarding, Adverse Selection, Self-insurance
    JEL: E44 G11
    Date: 2010–03
  7. By: Edith Cohen; Michal Feldman; Amos Fiat; Haim Kaplan; Svetlana Olonetsky
    Abstract: We study auctions with additive valuations where agents have a limit on the number of items they may receive. We refer to this setting as capacitated allocation games. We seek truthful and envy free mechanisms that maximize the social welfare. I.e., where agents have no incentive to lie and no agent seeks to exchange outcomes with another. In 1983, Leonard showed that VCG with Clarke Pivot payments (which is known to be truthful, individually rational, and have no positive transfers), is also an envy free mechanism for the special case of n items and n unit capacity agents. We elaborate upon this problem and show that VCG with Clarke Pivot payments is envy free if agent capacities are all equal. When agent capacities are not identical, we show that there is no truthful and envy free mechanism that maximizes social welfare if one disallows positive transfers. For the case of two agents (and arbitrary capacities) we show a VCG mechanism that is truthful, envy free, and individually rational, but has positive transfers. We conclude with a host of open problems that arise from our work.
    Date: 2010–02
  8. By: Robert S. Gibbons; Richard T. Holden; Michael L. Powell
    Abstract: We analyze a rational-expectations model of price formation in an intermediate-good market under uncertainty. There is a continuum of dyads, each consisting of an upstream party and a downstream party. Both parties can make specific investments at private cost, and there is a machine that either party can own. As in property-rights models, different ownership structures create different incentives for the parties’ investments. As in rational-expectations models, some parties may invest in acquiring information, which is then incorporated into the market-clearing price by the parties’ trading behaviors. The informativeness of the price mechanism affects the returns to specific investments and hence the optimal ownership structure for individual dyads; meanwhile, the ownership choices by individual dyads affect the informativeness of the price mechanism. In equilibrium the informativeness of the price mechanism can induce ex ante homogenous dyads to choose heterogeneous ownership structures.
    JEL: D2 D23
    Date: 2010–02
  9. By: Christopher J. Ellis; John Fender
    Abstract: We combine Acemoglu and Robinson’s model of the economic origins of democracy with Lohmann’s model of political mass protest. This allows us to analyze the economic causes of political regime change based on the microfoundations of revolution. We are able to derive conditions under which democracy arises peacefully, when it occurs only after a revolution, and when oligarchy persists. We model these possibilities in a world of asymmetric information where information cascades are possible, and where these cascades may involve errors in the sense that they make everyone worse off.
    Keywords: Democracy, Information Cascades, Revolution
    JEL: H0 P4 P16
    Date: 2010–01
  10. By: Robert S. Gibbons; Richard T. Holden; Michael L. Powell
    Abstract: We analyze a rational-expectations model of information acquisition and price formation in an intermediate- good market: prices and net supply are non-negative, there are no noise traders, and the intermediate good has multiple potential uses. Several of our results differ from the classic Grossman-Stiglitz approach. For example, the price mechanism is more informative at high and low prices and potentially uninformative at middle prices. Also, an informed trade by a producer of one final good amounts to a noise trade from the perspective of a producer of another final good, so (a) as the price mechanism becomes more informative for producers of one final good, it becomes less informative for producers of others, who therefore have a stronger incentive to acquire information, so information acquisition has the strategic-complements property between groups, and (b) having more producers (in multiple groups) become informed need not increase the informativeness of the price mechanism.
    JEL: D80 G10
    Date: 2010–02
  11. By: Natalia (University of Padua)
    Abstract: Relying on the relevance of other-regarding preferences in workplaces, the paper provides a behavioral explanation for the puzzle of unpaid overtime. It characterizes the optimal compensation schemes offered by the employer which induce overtime by exploiting workers’ horizontal reciprocity under both symmetric and asymmetric information about workers’ action. Finally, the paper shows that reciprocity furnishes a rationale for the composition of teams of reciprocal workers when the production technology induces negative externality among the employees’ efforts.
    Keywords: Overtime, Horizontal Reciprocity, Negative Reciprocity.
    Date: 2010–02
  12. By: Francesco Giuli (University of Rome La Sapienza, Department of Public Economics, Italy); Marco Manzo (Ministry of Economics, Italy and OECD)
    Abstract: We apply a three-tier hierarchical model of regulation, developed along the lines of Laffont and Tirole (1993), to an adverse selection problem in the corporate bond market. The bank brings the bonds to the market and informs the potential buyers about the bond risks; a unique benevolent public authority aims at maximising investors welfare. The main goal is to investigate whether this unique authority is able to fully inform the market on a firms true credit worthiness when banks, in order to recover doubtful credits, favour the placement of bonds issued by levered firms by concealing their true risk. By establishing the necessary conditions that allow optimal sanctions to produce the first best equilibrium, we show that the core problem of adverse selection in the corporate bond market does not lie so much in the benevolence of the delegated monitoring system, but rather in the possibility of affecting and sanctioning a firms behaviour.
    Keywords: Corporate bond, Incentives, Collusion, Regulation
    JEL: D82 G28
    Date: 2009–11
  13. By: Jan Boone; Jacob K. Goeree
    Abstract: This paper introduces three methodological advances to study the optimal design of static and dynamic markets. First, we apply a mechanism design approach to characterize all incentive-compatible market equilibria. Second, we conduct a normative analysis, i.e. we evaluate alternative competition and innovation policies from a welfare perspective. Third, we introduce a reliable way to measure competition in dynamic markets with non- linear pricing. We illustrate the usefulness of our approach in several ways. We reproduce the empirical finding that innovation levels are higher in markets with lower price-cost margins, yet such markets are not necessarily more competitive. Indeed, we prove the Schumpeterian conjecture that more dynamic markets characterized by higher levels of innovation should be less competitive. Furthermore, we demonstrate how our approach can be used to determine the optimal combination of market regulation and innovation policies such as R&D subsidies or a weakening of the patent system. Finally, we show that optimal markets are characterized by strictly positive price-cost margins.
    JEL: D4 L51
    Date: 2010–02
  14. By: Charlotte Klempt (Max Planck Institute of Economics, Jena); Kerstin Pull (Eberhard-Karls-Universität Tübingen, Faculty of Economics and Business Administration)
    Abstract: Sanctions are widely used to promote compliance in principal-agent-relationships. While there is ample evidence confirming the predicted positive incentive effect of sanctions, it has also been shown that imposing sanctions may in fact reduce compliance by crowding-out intrinsic motivation. We add to the literature on the hidden costs of control by showing that these costs are restricted to situations where principals ex ante reveal their decision to sanction low compliance. If this decision is not revealed and agents do not know whether they will be sanctioned or not in case of low compliance, we do not find evidence of crowding-out - not even in those cases where agents firmly believe that they will be sanctioned in case of low performance.
    Keywords: Intrinsic Motivation, Monetary Incentives, Job Performance
    JEL: C72 C91
    Date: 2010–03–03
  15. By: Noga Alon; Michal Feldman; Ariel D. Procaccia; Moshe Tennenholtz
    Abstract: We consider the problem of locating a facility on a network, represented by a graph. A set of strategic agents have different ideal locations for the facility; the cost of an agent is the distance between its ideal location and the facility. A mechanism maps the locations reported by the agents to the location of the facility. Specifically, we are interested in social choice mechanisms that do not utilize payments. We wish to design mechanisms that are strategyproof, in the sense that agents can never benefit by lying, or, even better, group strategyproof, in the sense that a coalition of agents cannot all benefit by lying. At the same time, our mechanisms must provide a small approximation ratio with respect to one of two optimization targets: the social cost or the maximum cost. We give an almost complete characterization of the feasible truthful approximation ratio under both target functions, deterministic and randomized mechanisms, and with respect to different network topologies. Our main results are: We show that a simple randomized mechanism is group strategyproof and gives a tight approximation ratio of 3/2 for the maximum cost when the network is a circle; and we show that no randomized SP mechanism can provide an approximation ratio better than 2-o(1) to the maximum cost even when the network is a tree, thereby matching a trivial upper bound of two.
    Date: 2010–02

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