nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2010‒07‒24
fifteen papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Infinite-Horizon Mechanism Design By Alessandro Pavan; Ilya Segal; Juuso Toikka
  2. Contract Design to Sequester Carbon in Agricultural Soils By Mireille CHIROLEU-ASSOULINE; Sébastien ROUSSEL
  3. A Theory of Firm Decline By Gian Luca Clementi; Thomas Cooley; Sonia Di Giannatal
  4. Competition relative to Incentive Contracts in Common Agency By Seungjin Han
  5. The incentive for prevention in public health Systems By Renaud Bourlès
  6. Rhetoric in Legislative Bargaining with Asymmetric Information By Ying Chen; Hülya Eraslan
  7. Asymmetric Information and Market Collapse By Paresh Kumar Narayan; Xinwei Zheng
  8. Information transmission and the emergence of a peculiar trading facility in certain emerging markets By Siddiqi, Hammad
  9. Microfinance and Mechanism Design: The Role of Joint Liability and Cross-Reporting By Abdul Karim, Zulkefly
  10. Leniency in Private Regulatory Enforcement: The Role of Organizational Scope and Governance By Lamar Pierce; Michael W. Toffel
  11. On favoritism in auctions with entry By Leandro Arozamena; Federico Weinschelbaum
  12. Nash Equilibrium and information transmission coding and decoding rules By Penelope Hernandez; Amparo Urbano Salvador; Jose E. Vila
  13. Illiquidity and all its Friends By Jean Tirole
  14. Moral hazard, peer monitoring, and microcredit: field experimental evidence from Paraguay By Jeffrey Carpenter; Tyler Williams
  15. Informational Externalities and Resource Allocations in Asymmetric First Price Menu Auction By Seungjin Han

  1. By: Alessandro Pavan; Ilya Segal; Juuso Toikka
    Abstract: These notes examine the problem of how to extend envelope theorems to infinite-horizon dynamic mechanism design settings, with an application to the design of "bandit auctions."
    Keywords: asymmetric information, stochastic processes, incentives, mechanism design JEL Classification Numbers: D82, C73, L1.
    Date: 2010–07–16
  2. By: Mireille CHIROLEU-ASSOULINE; Sébastien ROUSSEL
    Abstract: According to several studies, agricultural carbon sequestration could be a relatively low cost opportunity to mitigate greenhouse gas (GHG) concentration and a promis-ing means that could be institutionalised. However the potential for additional carbon quantities in agricultural soils is critical and comes from the agricultural .rms behaviour with regards to land heterogeneity. In this paper, our aim is to set incentive mechanisms to enhance carbon sequestration by agricultural .rms. A policymaker has to arrange incentives as agricultural .rms have private information and do not spontaneously switch to the required practices. Moreover, a novelty in our paper is to show that the potential for additional carbon sequestration is similar to an exhaustible resource. As a result, we construct an intertemporal principal-agent model with adverse selection. Our contribution is to specify contracts in order to induce truthful revelation by the .rms regarding their intrinsic characteristics towards carbon sequestration, while analytically characterizing the optimal path to sequester carbon as an exhaustible resource.
    Date: 2010–07
  3. By: Gian Luca Clementi (New York University and RCEA); Thomas Cooley (New York University and NBER); Sonia Di Giannatal (Centro de Investigación y Docencia Económicas)
    Abstract: We study the problem of an investor that buys an equity stake in an entrepreneurial venture, under the assumption that the former cannot monitor the latter’s operations. The dynamics implied by the optimal incentive scheme is rich and quite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, invested capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision is costlier the wealthier the entrepreneur (the greater is inside equity). In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment.
    Keywords: Principal Agent, Moral Hazard, Hidden Action, Incentives, Survival, Firm Dynamics
    JEL: D82 D86 D92 G32
    Date: 2010–06
  4. By: Seungjin Han
    Abstract: In most common agency problems, competing principals non-coop- eratively incentivize a privately-informed agent’s action choice with monetary transfer by o?ering incentive contracts (e.g., nonlinear prices) that specify the amounts of monetary transfer as a function of the part of the agent’s action that is contractible. This paper shows that when- ever contracting in common agency involves monetary transfer, the set of all equilibrium allocations relative to incentive contracts is identi- cal to the set of all equilibrium allocations relative to any complex mechanisms that assign incentive contracts contingent on the agent’s messages.
    Keywords: mechanism design; incentive contracts; nonlinear prices; common agency
    JEL: D82 C72
    Date: 2010–07
  5. By: Renaud Bourlès (École Centrale de Marseille and Greqam)
    Abstract: This paper examines the effect of moral hazard on public health insurance contract. It models primary prevention in a two period model with classification risk. Agent’s preferences appear to play an important role in the optimal determination of preventive effort and insurance between generations. If absolute prudence is larger than twice absolute risk aversion, moral hazard increases intergenerational insurance and classification risk. This highlights a tradeoff between prevention and insurance arising from classification risk. An increase in the difference between prudence and twice risk aversion (that we define as the degree of “protectiveness”) moreover makes public insurance contracts more stable (when competing with spot insurance) if the cost of prevention is low enough when agents preferences exhibit CRRA. Under a formulated utility function with linear reciprocal derivative, we finally show that an increase in agent’s degree of “protectiveness” enhances the stability of public insurance and the extent of intergenerational insurance.
    Keywords: Public health insurance; Classification risk; Moral Hazard; Prudence.
    JEL: D81 D91 G22
    Date: 2010–02–17
  6. By: Ying Chen (Arizona State University); Hülya Eraslan (John Hopkins University)
    Abstract: In this paper we analyze a legislative bargaining game in which parties privately informed about their preferences bargain over an ideological and a distributive decision. Communication takes place before a proposal is offered and majority rule voting determines the outcome. When the private information pertains to the ideological intensities but the ideological positions are publicly known, it may not be possible to have informative communication from the legislator who is ideologically distant from the proposer, but the more moderate legislator can communicate whether he would "compromise" or fight" on ideology. If instead the private information pertains to the ideological positions, then all parties may convey whether they will "cooperate," "compromise," or fight" on ideology. When the uncertainty is about ideological intensity, the proposer is always better on making proposals for the two dimensions together despite separable preferences, but when the uncertainty is about ideological positions, bundling can result in informational loss which hurts the proposer.
    JEL: C78 D72 D82 D83
    Date: 2010–07
  7. By: Paresh Kumar Narayan; Xinwei Zheng
    Abstract: In this paper, using data for the period January 1995 to May 2009 for the Shanghai stock exchange (SHSE), we show that aggregate illiquidity is a priced risk factor. We develop the relationship between the illiquidity factor, asymmetric information, and market collapse. Our empirical results show that while the illiquidity factor is a source of asymmetric information on the SHSE, asymmetric information does not trigger a market collapse.
    Keywords: Illiquidity Factor; Asymmetric Information; Market Collapse.
    Date: 2010–07–16
  8. By: Siddiqi, Hammad
    Abstract: A peculiar carry over transaction facility has been associated with emerging markets of India and Pakistan. We show that the trading facility can be considered a market response to the information gaps in these markets. Information can be credibly transmitted through this trading facility. Hence, the emergence of such a trading facility is, perhaps, an example of a creative market response to information problems.
    Keywords: Information Asymmetry; Information Transmission; Emerging Markets; Perfect Bayesian Equilibria; Badla Finance
    JEL: N20 D82 G10 D00
    Date: 2010–04–11
  9. By: Abdul Karim, Zulkefly
    Abstract: Since the establishment of Grameen Bank in 1976 by Professor Muhammad Yunus , many economists have studied extensively, either theoretically or empirically, the success of the Grameen Bank in eradicating the poverty problem in Bangladesh. Therefore, this paper aims to apply the mechanism design theory in microfinance by examining the role of joint liability and cross-reporting mechanism in the loan contract which designing by microfinance lender. In doing so, this study simplified the joint liability mechanism proposed by Ghatak (1999, 2000) and cross-reporting mechanism by Rai and Sjostrom (2004). Based on the joint-liability mechanism, it is clearly stated that the microfinance lender can minimize or avoid the adverse selection problem in the credit market through peer selection and peer screening. In the meantime, the joint liability mechanism is better than individual lending in terms of increasing the social welfare among the poor borrower, charging lower interest rates and generating high repayment rates. In contrast, Rai and Sjostrom (2004) argue that joint liability alone is not enough to efficiently induce borrowers to help each other. Indeed, the cross-reporting mechanism is also important for lenders in order to minimize the problem of asymmetric information in the credit market. The cross-reporting mechanism is also efficient because it can influence the borrower to be truthful-telling about the state of the project and subsequently can minimize the deadweight loss (punishment) among the borrowers. In comparison, without cross-reporting, the lending mechanism is inefficient because the borrower will be imposed harsh punishment from the bank and the bank can undertake auditing or verify the state of the project and punish accordingly.
    Keywords: Microfinance; mechanism design; joint liability; cross-reporting
    JEL: B21 N20 C70
    Date: 2009–07–10
  10. By: Lamar Pierce (Olin Business School, Washington University in St. Louis); Michael W. Toffel (Harvard Business School, Technology and Operations Management Unit)
    Abstract: Profit-seeking firms can present efficiency improvements when performing functions traditionally relegated to government. Yet these potential cost-efficiencies from market competition are often offset by poor enforcement quality resulting from moral hazard, which can be particularly onerous when outsourcing enforcement of government regulation. In this paper, we argue that the considerable moral hazard of private regulatory enforcement can be mitigated by the scope of organizations' product/service portfolios and by private governance mechanisms. These organizational characteristics affect the stringency of enforcement through reputation and customer loyalty, differential impacts of government sanctions, and standardization and internal monitoring of operations. We test our theory in the context of vehicle emissions testing in a state in which the government has outsourced inspection and enforcement to private sector establishments. Analyzing millions of emissions tests, we find empirical support for our hypotheses that particular forms of firm governance and product portfolios can mitigate moral hazard.
    Date: 2010–07
  11. By: Leandro Arozamena; Federico Weinschelbaum
    Abstract: We examine the problem of endogenous entry in a single-unit auction when the seller's welfare depends positively on the utility of a subset of potential bidders. We show that, unless the seller values those bidders' welfare more than her own "private" utility, a nondiscriminatory auction is optimal.
    Keywords: auctions, favoritism, free entry, endogenous number of bidders.
    JEL: C72 D44
    Date: 2010–07
  12. By: Penelope Hernandez (ERI-CES); Amparo Urbano Salvador (ERI-CES); Jose E. Vila (ERI-CES)
    Abstract: The design of equilibrium protocols in sender-receiver games where communication is noisy occupies an important place in the Economic literature. This paper shows that the common way of constructing a noisy channel communication protocol in Information Theory does not necessarily lead to a Nash equilibrium. Given the decoding scheme, it may happen that, given some state, it is better for the sender to transmit a message that is different from that prescribed by the codebook. Similarly, when the sender uses the codebook as prescribed, the receiver may sometimes prefer to deviate from the decoding scheme when receiving a message.
    Keywords: Noisy channel, Shannon's Theorem, sender-receiver games, Nash equilibrium
    JEL: C72 C02
    Date: 2010–07
  13. By: Jean Tirole (Toulouse School of Economics)
    Abstract: The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macro-prudential policies.
    Keywords: Liquidity, Contagion, Bailouts, Regulation
    JEL: E44 E52 G28
    Date: 2010–06
  14. By: Jeffrey Carpenter; Tyler Williams
    Abstract: Given the substantial amount of resources currently invested in microcredit programs, it is more important than ever to accurately assess the extent to which peer monitoring by borrowers faced with group liability contracts actually reduces moral hazard. We conduct a field experiment with women about to enter a group loan program in Paraguay and then gather administrative data on the members' repayment behavior in the six-month period following the experiment. In addition to the experiment which is designed to measure individual propensities to monitor under incentives similar to group liability, we collect a variety of the other potential correlates of borrowing behavior and repayment. Controlling for other factors, we find a very strong causal relationship between the monitoring propensity of one's loan group and repayment. Our lowest estimate suggests that borrowers in groups with above median monitoring are 36 percent less likely to have a problem repaying their portion of the loan. Besides confirming a number of previous results, we also find some evidence that risk preferences, social preferences, and cognitive skills affect repayment.
    Keywords: Loans ; Credit ; Human behavior
    Date: 2010
  15. By: Seungjin Han
    Abstract: This paper studies resource allocations in rst price menu auctions, with asymmetric bidders, interdependent values, and aliated signals, in which bidders submit menus of multidimensional contracting decisions. Interdependent values generically cause coordination problems on bidders' beliefs about how likely the decision maker would choose the bilaterally ex-post ecient contracting decisions in menus. This paper establishes the existence of a continuum of truthful monotone equilibria that spans the entire space of bidders' beliefs. It analyzes the nature of competition and the properties of truthful monotone equilibrium allocations including the robustness to bidders' beliefs on the decision maker's choice behavior.
    Keywords: first price menu auctions; truthful monotone equilibria; coordination; robustness
    JEL: D82 C72
    Date: 2010–07

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