nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2010‒05‒15
sixteen papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Gift-Exchange, Incentives, and Heterogeneous Workers By Arjan Non
  2. Relationship Finance, Market Finance and Endogenous Business Cycles By L.Deidda; B.Fattouh
  3. Directed Search in the Housing Market By James Albrecht; Pieter A. Gautier; Susan Vroman
  4. How to Deal with Covert Child Labour, and Give Children an Effective Education, in a Poor Developing Country : An Optimal Taxation Problem with Moral Hazard By Cigno, Alessandro
  5. What do we pay for asymmetric information? The evolution of mechanisms in online markets By Chen, Liyun
  6. Two-period economies with private state verification By Joao Correia-da-Silva; Carlos Herves-Beloso
  7. Over-the-counter loans, adverse selection, and stigma in the interbank market By Huberto M. Ennis; John A. Weinberg
  8. Common Knowledge of Rationality and Market Clearing in Economies with Asymmetric Information By Elchanan Ben-Porath; Aviad Heifetz
  9. Bank liability insurance schemes before 1865 By Warren E. Weber
  10. Rational Expectations in Urban Economics By Berliant, Marcus; Yu, Chia-Ming
  11. Tainted Food, Low-Quality Products and Trade By Jean-Marie Viaene; Laixun Zhao
  12. Dynamic relational contracts with credit constraints By Jonathan Thomas; Tim Worrall
  13. Auctioning Incentive Contracts: An Experimental Study By Sander Onderstal; Arthur Van de Meerendonk
  14. A Multi Agent Model for the Limit Order Book Dynamics By Marco Bartolozzi
  15. Auctions with Flexible Entry Fees By Maarten Janssen; Vladimir A. Karamychev; Emiel Maasland
  16. Marketing Social Responsibility By Sumitro Banerjee; Luc Wathieu

  1. By: Arjan Non (Erasmus University Rotterdam)
    Abstract: Using a formal principal-agent model, I investigate the relation between monetary gift-exchange and incentive pay, while allowing for worker heterogeneity. I assume that some agents care more for their principal when they are convinced that the principal cares for them. Principals can signal their altruism by offering a generous contract, consisting of a base salary and an output-contingent bonus. I find that principals signal their altruism by offering relatively weak incentives and a relatively high expected total compensation, but the latter does not necessarily hold. Furthermore, since some agents do not reciprocate the principal's altruism, the principal may find it optimal to write a contract that simultaneously signals his altruism and screens reciprocal worker types. I show that such a contract is characterised by excessively strong incentives and relatively high expected total compensation.
    Keywords: reciprocity; gift-exchange; signaling game; incentive contracts; screening
    JEL: D86 J41 M52 M55
    Date: 2010–01–06
  2. By: L.Deidda; B.Fattouh
    Abstract: This paper develops an overlapping generation model with asymmetric information in the credit market such that the interplay between relationship finance supplied by investors who monitor investment decisions ex-ante and market finance supplied by investors who relay on public information can be the source of endogenous business fluctuations. Monitoring helps reducing the inefficiency caused by moral hazard. However, the incentives of entrepreneurs to demand relationship finance to induce monitoring –which is also non-contractible – are weaker the lower is the return to investment. If the return to investment is low enough, entrepreneurs demand too little relationship finance. This leads to an inefficiently low level of monitoring and of entrepreneurial effort. Under decreasing marginal returns to capital, the model generates a reversion mechanism that can induce macroeconomic instability. The economy can experience endogenous business cycles characterized by a pro-cyclical behavior of the relative importance of relationship finance. This is consistent with the pro-cyclical behavior of the indicator of relative importance of relationship finance, which we construct based on quarterly and annual data from the US Flow of Funds Accounts for the non-financial corporate business sector.
    Keywords: Moral hazard; Endogenous business cycles; relationship finance; market finance; Monitoring
    JEL: D82 E32 E44
    Date: 2010
  3. By: James Albrecht (Georgetown University); Pieter A. Gautier (VU University Amsterdam); Susan Vroman (Georgetown University)
    Abstract: In this paper, we present a directed search model of the housing market. The pricing mechanism we analyze reflects the way houses are bought and sold in the United States. Our model is consistent with the observation that houses are sometimes sold above, sometimes below and sometimes at the asking price. We consider two versions of our model. In the first version, all sellers have the same reservation value. In the second version, there are two seller types, and type is private information. For both versions, we characterize the equilibrium of the game played by buyers and sellers, and we prove efficiency. Our model offers a new way to look at the housing market from a search-theoretic perspective. In addition, we contribute to the directed search literature by considering a model in which the asking price (i) entails only limited commitment and (ii) has the potential to signal seller type.
    Keywords: Directed Search; Housing
    JEL: D83 R31
    Date: 2010–01–04
  4. By: Cigno, Alessandro
    Abstract: As the return to education (and possibly also parental income) is uncertain, and given that the work a child does covertly for his own parents, and transfers between parents and children, are private information, the government should make school enrollment compulsory, set a legal limit (decreasing in parental income) on overt child labour, and redistribute across families using a flat-rate education grant, and a tax on parental income. That done, it should use a scholarship increasing in school results, and a tax on the skill premium, to raise the expected return to educational investment, and make it less uncertain.
    Keywords: child labour, education, uncertainty, moral hazard
    JEL: D82 H21 H31 I28 J24
    Date: 2010–04
  5. By: Chen, Liyun
    Abstract: The appearance of the Internet reduces transaction costs greatly, and brings the boom of online markets. While we are trying to regard it as the most realistic approximation of perfect competition market, the asymmetric information and a series of problems caused by it stop us from dreaming. As the old saying goes, there is no free lunch. This summer witnessed the collapse of the reputation system in Taobao, the biggest online transaction website in China. In fact, during the evolution of mechanisms in online markets, reputation, punishment and barriers to entry have been established in turn. What do we pay for maintaining these mechanisms? In which circumstance will they be effective? In this paper I try to build a series of models within the principal-agent frame- work and repeated games to explain why and what we should pay for asymmetric information while enjoying shopping online. Specifically, these mechanisms are considered step by step and their boundary validation conditions are discussed. Finally, as the conclusion indicates, the more range that a mechanism is effective, the more opportunity cost should be paid as a rent for information.
    Keywords: online market; mechanism design; reputation;
    JEL: L14 L1
    Date: 2009–11–20
  6. By: Joao Correia-da-Silva (CEF.UP and Faculdade de Economia, Universidade do Porto); Carlos Herves-Beloso (RGEA, Facultad de Economicas, Universidad de Vigo)
    Abstract: Private state verification is introduced in a two-period economy with spot markets in both periods and complete futures markets for contingent delivery in the second period. Existence of equilibrium is established, under standard assumptions. An example is presented in which a complete set of contingent markets allows agents to arrive at the optimal allocation of risk-bearing, while securities are not sufficient.
    Keywords: General equilibrium, Asymmetric information, Private state verification, Two-period economies
    JEL: C62 C72 D51 D82
    Date: 2010–05
  7. By: Huberto M. Ennis; John A. Weinberg
    Abstract: It is often the case that banks in the US are willing to borrow in the fed funds market (the interbank market for funds) at higher rates than the ones they could obtain by borrowing at the Fed's discount window. This phenomenon is commonly explained as the consequence of the existence of a stigma effect attached to borrowing from the window. Most policymakers and empirical researchers consider the stigma hypothesis plausible. Yet, no formal treatment of the issue has ever been provided in the literature. In this paper, we fill that gap by studying a model of interbank credit where: (1) banks benefit from engaging in intertemporal trade with other banks and with outside investors; and (2) physical and informational frictions limit those trade opportunities. In our model, banks obtain loans in an over-the-counter market (involving search, bilateral matching, and negotiations over the terms of the loan) and hold assets of heterogeneous qualities which in turn determine their ability to repay those loans. When asset quality is not observable by outside investors, information about the actions taken by a bank in the credit market may influence the price at which it can sell its assets. In particular, under some conditions, discount window borrowing may be regarded as a negative signal about the quality of the borrower's assets. In such cases, some of the banks in our model, just as in the data, are willing to accept loans in the interbank market at higher rates than the ones they could obtain at the discount window.
    Date: 2010
  8. By: Elchanan Ben-Porath; Aviad Heifetz
    Abstract: Consider an exchange economy with asymmetric information. What is the set of outcomes that are consistent with common knowledge of rationality and market clearing? To address this question we de…ne an epistemic model for the economy that provides a complete description not only of the beliefs of each agent on the relationship between states of nature and prices but also of the whole system of interactive beliefs. The main result, theorem 1, provides a characterization of outcomes that are consistent with common knowledge of rationality and market clearing (henceforth, CKRMC outcomes) in terms of a solution notion - Ex - Post Rationalizability - that is defi…ned directly in terms of the parameters that de…ne the economy. We then apply theorem 1 to characterize the set of CKRMC outcomes in a general class of economies with two commodities. CKRMC manifests several intuitive properties that stand in contrast to the full revelation property of Rational Expectations Equilibrium: In particular, we obtain that for a robust class of economies: (1) there is a continuum of prices that are consistent with CKRMC in every state of nature, and hence these prices do not reveal the true state, (2) the range of CKRMC outcomes is monotonically decreasing as agents become more informed about the economic fundamentals, and (3) trade is consistent with common knowledge of rationality and market clearing even when there is common knowledge that there are no mutual gains from trade.
    Keywords: Common Knowledge of Rationality and Market Clearing in Economies with Asymmetric Information
    JEL: D84 D50
    Date: 2010–03–01
  9. By: Warren E. Weber
    Abstract: Prior to the Civil War several states established bank liability insurance schemes of two basic types. One was an insurance fund, in which member banks paid into a state-run fund that would pay losses of bank creditors. The other was a mutual guarantee system, in which survivor banks were legally responsible the liabilities of any bank that became insolvent. Both schemes did well at insuring bank creditors, but neither prevented bank panics. Bank failure rates were somewhat higher for banks that were part of these schemes. The experience with these schemes shows that regulatory incentives matter for controlling moral hazard. The schemes that provided the most control of moral hazard were those that had a high degree of mutuality of losses borne by all banks participating in the scheme.
    Keywords: Deposit insurance ; Moral hazard ; Bank notes
    Date: 2010
  10. By: Berliant, Marcus; Yu, Chia-Ming
    Abstract: Canonical analysis of the classical general equilibrium model demonstrates the existence of an open and dense subset of standard economies that possess fully-revealing rational expectations equilibria. This paper shows that the analogous result is not true in urban economies under reasonable modifications for this field. An open subset of economies where none of the modified rational expectations equilibria fully reveals private information is found. There are two important pieces. First, there can be information about a location known by a consumer who does not live in that location in equilibrium, and thus the equilibrium rent does not reflect this information. Second, if a consumer's utility depends only on information about their (endogenous) location of residence, perturbations of utility naturally do not incorporate information about other locations conditional on their location of residence. Existence of equilibrium is proved. Space can prevent housing prices from transmitting information from informed to uninformed households, resulting in an inefficient outcome.
    Keywords: Urban Economics; General Equilibrium; Private Information; Rational Expectations
    JEL: R13 D82 D51
    Date: 2010–05–08
  11. By: Jean-Marie Viaene (Erasmus University Rotterdam, and CESifo); Laixun Zhao (Kobe University)
    Abstract: This paper examines international trade in tainted food and other low-quality products. We
    Keywords: asymmetric information; experience good; product differentiation; sabotage; tainting; testing errors; trade
    JEL: D43 F12 F13 I12
    Date: 2010–01–04
  12. By: Jonathan Thomas; Tim Worrall
    Date: 2010
  13. By: Sander Onderstal (University of Amsterdam); Arthur Van de Meerendonk (Maastricht University)
    Abstract: In this note, we experimentally examine the relative performance of price-only auctions and multi-attribute auctions. We do so in procurement settings where the buyer can give the winning bidder incentives to exert effort on non-price dimensions after the auction. Both auctions theoretically implement the surplus maximizing mechanism. Our experiment confirms this result. Moreover, we observe that the “pie” is shared the same in both auctions between buyer and suppliers both in theory and in the lab (after accounting for learning effects).
    Keywords: Procurement; Price-only auctions; Multi-attribute auctions; Incentive Contracts; Laboratory Experiment
    JEL: C91 D44 D86
    Date: 2009–11–13
  14. By: Marco Bartolozzi
    Abstract: In the present work we introduce a novel multi-agent model with the aim to reproduce the dynamics of a double auction market at microscopic time scale through a faithful simulation of the matching mechanics in the limit order book. The model follows a "zero intelligence" approach where the actions of the traders are related to a stochastic variable, the market sentiment, which we define as a mixture of public and private information. The model, despite the parsimonious approach, is able to reproduce several empirical features of the high-frequency dynamics of the market microstructure not only related to the price movements but also to the deposition of the orders in the book.
    Date: 2010–05
  15. By: Maarten Janssen (University of Vienna, and Erasmus University Rotterdam); Vladimir A. Karamychev; Emiel Maasland (Erasmus School of Economics, Erasmus University Rotterdam)
    Abstract: There is by now a large literature arguing that auctions with a variety of after-market interactions may not yield an efficient allocation of the objects for sale, especially when the bidders impose strong negative externalities upon each other. This paper argues that these inefficiencies can be avoided by asking bidders prior to the auction to submit any public payment they would like to make. These payments, so-called flexible entry fees, do not affect the allocation decision of the auctioneer. We show that auctions with flexible entry fees have a fully revealing equilibrium where bidders signal their type before the auction itself takes place.
    Keywords: auctions; efficiency; entry fee; negative externality; revenue
    JEL: C72 D44
    Date: 2009–11–30
  16. By: Sumitro Banerjee (ESMT European School of Management and Technology); Luc Wathieu (ESMT European School of Management and Technology)
    Abstract: This paper analyzes the optimal strategy of a profit-maximizing firm in response to social responsibility concerns of consumers. We show that firms will address responsibility demands if consumers are sufficiently motivated and society provides minimal monitoring of false claims. We further show that there is an interaction between the firm’s basic positioning and the type of responsibility initiative it undertakes. A firm selling a low quality product commits to social responsibility in the form of good citizenship by investing in compliance with social norms valued by all consumers. In contrast, a firm selling a high quality product tends to contribute to social causes endorsed by its target customers. Under asymmetric information, when consumers cannot observe product quality, we find that a firm can signal its commitment to social responsibility by charging a higher price and by making exaggerated claims that would be too damaging if they were not largely true. Finally, in a vertically differentiated duopoly, we find that only one firm will take on social responsibility initiatives. Overall, these findings suggest that profit-driven competitive marketing strategies can fulfill social responsibility just as much as any other driver of consumer utility.
    Keywords: corporate social responsibility, cause marketing, signaling games
    JEL: D42 D21 M3 M14
    Date: 2010–03–22

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