nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2010‒09‒11
seventeen papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Moral hazard and risk-sharing: risk-taking as an incentive tool By Mohamed Belhaj; Renaud Bourlès; Frédéric Deroïan
  2. Optimal Mechanisms for an Auction Mediator By Alexander Matros; Andriy Zapechelnyuk
  3. "Role of Relative and Absolute Performance Evaluations in Intergroup Competition" By Hitoshi Matsushima
  4. Incomplete Information and Rent Dissipation in Deterministic Contests By Rene Kirkegaard
  5. Making Sense of Non-Binding Retail-Price Recommendations By Gärtner, Dennis L; Buehler, Stefan
  6. Incentive provision when contracting is costly By Kvaløy, Ola; Olsen, Trond E.
  7. Knowing Versus Telling Private Information About a Rival By Mark Bagnoli; Susan G. Watts
  8. The Role of Cybermediaries in the Hotel Market By Yacouel, Nira; Fleischer, Aliza
  9. Public information and IPO underpricing By Einar, Bakke; Leite, Tore E.; Thorburn, Karin S.
  10. A Second-Best Mechanism for Land Assembly By Grossman, Zachary; Pincus, Jonathan; Shapiro, Perry
  11. The fog of fraud – mitigating fraud by strategic ambiguity By Matthias Lang; Achim Wambach
  12. Optimal Monitoring for project-based Emissions Trading Systems under incomplete Enforcement By Markus Ohndorf
  13. The Role of the State in Managing and Forestalling Systemic Financial Crises: Some Issues and Perspectives By Charles Adams
  14. Financial Experts as an Arms Race By Glode, V.; Green, R.C.; Lowry, R.
  15. Strategic Insider Trading Equilibrium: A Filter Theory Approach By Aase, Knut K.; Bjuland, Terje; Øksendal, Bernt
  16. Managing Markets for Toxic Assets By House, Christopher; Masatlioglu, Yusufcan
  17. "Who's the thief?": Asymmetric Information and the Creation of Property Rights By Philipp Denter; Dana Sisak

  1. By: Mohamed Belhaj (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR6579); Renaud Bourlès (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR6579); Frédéric Deroïan (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR6579)
    Abstract: We examine how moral hazard impacts risk-sharing when risk-taking can be part of the mechanism design. In a two-agent model with binary effort, we show that moral hazard always increases risk-taking (that is the amount of wealth invested in a risky project) whereas the effect on risk-sharing (the amount of wealth transferred between agents) is ambiguous. Risk-taking therefore appears as a useful incentive tool. In particular, in the case of preferences exhibiting Constant Absolute Risk Aversion (CARA), moral hazard has no impact on risk-sharing and risk-taking is the unique mechanism used to solve moral hazard. Thus, risk-taking appears to be the prevailing incentive tool.
    Keywords: Risk-Taking, Informal Insurance, Moral Hazard
    Date: 2010–08–31
  2. By: Alexander Matros (University of South Carolina); Andriy Zapechelnyuk (Queen Mary, University of London)
    Abstract: We consider a dynamic auction environment with a long-lived seller and short-lived buyers mediated by a third party. A mediator has incomplete information about traders' values and selects an auction mechanism to maximize her expected revenue. We characterize mediator-optimal mechanisms and show that an optimal mechanism has a simple implementation as a Vickrey auction with a reserve price where the seller pays to the mediator only a fixed percentage from the closing price.
    Keywords: Optimal mechanism, Vickrey auction, Mediator
    JEL: C73 D44 D82
    Date: 2010–08
  3. By: Hitoshi Matsushima (Faculty of Economics, University of Tokyo)
    Abstract: We investigate the moral hazard problem in which a principal delegates multiple tasks to multiple workers. The principal imperfectly monitors their action choices by observing the public signals that are correlated with each other through a macro shock. He divides the workers into two groups and makes them compete with each other. We show that when the number of tasks is sufficiently large, relative performance evaluation between the groups accompanied with absolute performance evaluation results in eliminating unwanted equilibria. In this case, any approximate Nash equilibrium nearly induces the first-best allocation.
    Date: 2010–03
  4. By: Rene Kirkegaard (Department of Economics,University of Guelph)
    Abstract: In a deterministic contest or all-pay auction, all rents are dissipated when information is complete and contestants are identical. As one contestant becomes "stronger", that is, values the prize more, total expenditures are known to decrease monotonically. Thus, asymmetry among contestants reduces competition and rent dissipation. Recently, this result has been shown to hold for other, non-deterministic, contest success functions as well, thereby suggesting a certain robustness. In this paper, however, the complete information assumption is shown to be crucial. With incomplete information -- regardless of how little -- total expenditures in a deterministic two-player contest increase when one contestant becomes marginally stronger, starting from a symmetric contest. In fact, both contestants expend resources more aggressively; with complete information, neither of them do so.
    Keywords: All-pay auctions, Asymmetric auctions, Rent seeking.
    JEL: C72 D44 D72 D82
    Date: 2010
  5. By: Gärtner, Dennis L; Buehler, Stefan
    Abstract: We model non-binding retail-price recommendations (RPRs) as a communication device facilitating coordination in vertical supply relations. Assuming both repeated vertical trade and asymmetric information about production costs, we show that RPRs may be part of a relational contract, communicating private information from manufacturer to retailer that is indispensable for maximizing joint surplus. We show that this contract is self-enforcing if the retailer’s profit is independent of production costs and punishment strategies are chosen appropriately. We also extend our analysis to settings where consumer demand is variable or depends directly on the manufacturer’s RPRs. Keywords: vertical relationships, relational contracts, asymmetric information, price recommendations. JEL Classification: D23; D43; L14; L15.
    Date: 2009–10–15
  6. By: Kvaløy, Ola (Dept. of Economics and Business Administration, University of Stavanger); Olsen, Trond E. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
    Abstract: We analyze optimal incentive contracts in a model where the probability of court enforcement is determined by the costs spent on contracting. We show that contract costs matter for incentive provision, both in static spot contracts and repeated game relational contracts. We find that social surplus may be higher under costly relational contracting than under costless verifiable contracting, and show that there is not a monotonic relationship between contracting costs and incentive intensity. In particular we show that an increase in contracting costs may lead to higher-powered incentives. Moreover we formulate hypotheses about the relationship between legal systems and incentive provision, specifically the model predicts higher-powered incentives in common law than in civil law systems.
    Keywords: Contract costs; incentive provision
    JEL: J00
    Date: 2010–09–01
  7. By: Mark Bagnoli; Susan G. Watts
    Abstract: As part of a broad competitive intelligence strategy, firms expect to acquire information about their rivals’ customers and production processes. In this study, we examine the firms’ incentives to disclose this information. We find that firms adopt a policy of disclosing their information regardless of whether it concerns a rival’s customers or production costs or whether the firms are Cournot or Bertrand competitors. Firms that have private information about their rivals tell. Their willingness to disclose private information about their rivals contrasts with the results in the literature when the firm has information about itself. This literature shows that the chosen disclosure policy depends on whether information is about the firm’s own payoffs or industry demand and whether the firms’ strategies are substitutes or complements.
    Keywords: disclosure policy, voluntary disclosure, asymmetric information, Cournot competition, Bertrand competition
    JEL: G1 G14 M41
    Date: 2010–08
  8. By: Yacouel, Nira; Fleischer, Aliza
    Abstract: The advent of the Internet changed the way buyers and sellers interact. Although access to information seems unlimited, non-expert agents find it difficult to identify the information they can confidently use. A third-party expert or a cybermediary (an intermediary in the cyberspace) can help sort out the information for the contracting partners. In this paper, we study the case of the online hotel market and the role of the cyber travel agent (CTA). We claim that CTAs encourage hoteliers to exert effort in service quality and provide empirical evidence that these hotels are compensated with a price premium.
    Keywords: Cybermediaries, Internet, travel agents, reputation, hotel market, Agricultural Finance, Institutional and Behavioral Economics,
    Date: 2010
  9. By: Einar, Bakke (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Leite, Tore E. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Thorburn, Karin S. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
    Abstract: We analyze the effect of public information on rational investors' incentives to reveal private information during the bookbuilding process and their demand for allocations in the IPO. Our model generates several new predictions. First, investors require more underpricing to truthfully reveal positive private information in bear markets than in bull markets (the incentive effect). Second, the fraction of positive private signals and of underpriced IPOs is increasing in market returns (the demand effect). Combined, these two effects can explain why IPO underpricing is positively related to pre-issue market returns, consistent with extant evidence. Using a sample of 5,000 U.S. IPOs from 1981-2008, we show that the empirical implications of the model are borne out in the data.
    Keywords: Public information; partial adjustment; underpricing; IPOs; bookbuilding
    JEL: G10 G32
    Date: 2010–08–24
  10. By: Grossman, Zachary; Pincus, Jonathan; Shapiro, Perry
    Abstract: Land can be inefficiently allocated when attempts to assemble separately-owned pieces of land into large parcels are frustrated by holdout landowners. The existing land-assembly institution of eminent domain can be used neither to gauge efficiency nor to determine how to compensate displaced owners adequately. We take a mechanism-design approach to the assembly problem, formalizing it as a multilateral trade environment with perfectly complementary goods. We characterize the least-inefficient direct mechanism that is incentive compatible, self-financing, protects the property-rights of participants, and does not assume that participants have useful information about the subjective valuations of others. The second-best mechanism, which we call the Strong Pareto (SP) mechanism, utilizes a second-price auction among interested buyers, with a reserve sufficient to compensate fully all potential sellers, who are paid according to fixed and exhaustive shares of the winning buyer's offer. It may also internalize local externalities. While the SP mechanism only approves efficient sales, efficiency is not sufficient for sale---even with competitive bidding---because the auction reserve may exceed the aggregate seller valuation. The inefficiency of the second-best mechanism implies a Myserson-Satterthwaite (1981)-style impossibility theorem. We propose a criterion that encompasses concern for both efficiency and the rights of property owners to evaluate the relative performance of assembly mechanisms and the efficiency cost of strict adherence to individual rationality. In a simple example, we compare the expected outcome of the SP mechanism with two alternatives: a plurality mechanism based on SP, but with a lower reserve that is only high enough to fully compensate a plurality of owners and a stylized model of eminent domain.
    Keywords: land assembly, assembly problems, complementary goods, holdout, property rights, mechanism design, desirable properties, impossibility theorem, second-best characterization, SP mechanism, second-price auction, just compensation, local externalities, public-private partnerships
    Date: 2010–08–17
  11. By: Matthias Lang (Max Planck Institute for Research on Collective Goods, Bonn); Achim Wambach (University of Cologne)
    Abstract: Most insurance companies publish few data on the occurrence and detection of insurance fraud. This stands in contrast to the previous literature on costly state verification, which has shown that it is optimal to commit to an auditing strategy, as the credible announcement of thoroughly auditing claim reports might act as a powerful deterrent. We show that uncertainty about fraud detection can be an effective strategy to deter ambiguity-averse agents from reporting false insurance claims. If, in addition, the auditing costs of the insurers are heterogeneous, it can be optimal not to commit, because committing to a fraud detection strategy eliminates the ambiguity. Thus strategic ambiguity can be an equilibrium outcome in the market and competition does not force firms to provide the relevant information. This finding is also relevant in other auditing settings and complements the literature on games with ambiguity-averse players.
    Keywords: commitment, Ambiguity, Fraud, Strategic Uncertainty, Costly State Verification
    JEL: D8 K4
    Date: 2010–05
  12. By: Markus Ohndorf (Chair of Economics, Institute for Environmental Decisions IED, ETH Zurich)
    Abstract: Project-based Emissions Trading Schemes, like the Clean Development Mechanism, are particularly prone to problems of asymmetric information between the project parties and the regulator. Given the specificities of these schemes, the regulator’s optimal monitoring strategy significantly differs from the one to be applied for capand- trade schemes or environmental taxes. In this paper, we extend the general framework on incomplete enforcement of policy instruments to reflect these specificities. The main focus of the analysis is to determine the regulator’s optimal spot-check frequency under the plausible assumption that the submitted projects vary with respect to their verifiability. We find that, given a limited monitoring budget, the optimal monitoring strategy is discontinuous, featuring a jump within the set of projects with lower verifiability. In this region, actual abatement is low and can fall to zero. For these cases, the sign of the slope of the strategy function depends on the actual relationship of the abatement cost and the penalty function. We conclude that, in a real-world context, project admission should ultimately be based on the criterion of verifiability.
    Keywords: environmental regulation, emissions trading systems, audits and compliance
    JEL: K32 D42 D82
    Date: 2010–08
  13. By: Charles Adams (Asian Development Bank Institute)
    Abstract: This paper reviews recent state interventions in financial crises and draws lessons for crisis management. A number of areas are identified where crisis management could be strengthened, including with regard to the tools and instruments used to involve the private sector in crisis resolution (with a view to reducing the recent enhanced role of official bailouts and the associated moral hazard), to allow for the orderly resolution of systemically important financial firms (to make these firms “safe to fail”), and with regard to achieving better integration with ex ante macroprudential surveillance. The paper proposes the establishment of high level systemic risk councils (SRCs) in each country with responsibility for overseeing systemic risk in both tranquil times and crisis periods and coordinating the activities of key government ministries, agencies, and the central bank.
    Keywords: financial crisis, crisis management, private sector, moral hazard, systemic risk councils
    JEL: E58 E01
    Date: 2010
  14. By: Glode, V.; Green, R.C.; Lowry, R. (Tilburg University, Center for Economic Research)
    Abstract: We propose a model in which firms involved in trading securities overinvest in financial expertise. Intermediaries or traders in the model meet and bargain over a financial asset. As in the bargaining model in Dang (2008), counterparties endogenously decide whether to acquire information, and improve their bargaining positions, even though the information creates adverse selection. We add to this setting the concept of "financial expertise" as resources invested to lower the cost of later acquiring information about the value of the asset being traded. These investments are made before the parties know about their role in the bargaining game, as proposer or responder, buyer or seller. A prisoner's dilemma arises because investments to lower information acquisition costs improve bargaining outcomes given the other party's information costs, even though the information has no social benefit. These investments lead to breakdowns in trade, or liquidity crises, in response to random but infrequent increases in asset volatility
    Keywords: Financial services;over-the-counter markets;financial crisis
    JEL: G10 G20 D82
    Date: 2010
  15. By: Aase, Knut K. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Bjuland, Terje (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Øksendal, Bernt (Department of Mathematics, University of Oslo)
    Abstract: The continuous-time version of Kyle's (1985) model of asset pricing with asymmetric information is studied, and generalized in various directions, i.e., by allowing time-varying liquidity trading, and by having weaker a priori assumptions on the model. This extension is made possible by the use of filtering theory. We derive the optimal trade for an insider and the corresponding price of the risky asset; the insider's trading intensity satisfies a deterministic integral equation, given perfect inside information.
    Keywords: Insider trading; equilibrium; strategic trade; linear filter theory; innovation equation
    JEL: G12
    Date: 2010–09–01
  16. By: House, Christopher; Masatlioglu, Yusufcan
    Abstract: We present a model in which banks trade toxic assets to fund investments. Adverse selection in toxic assets reduces liquidity and investment. Investment is inefficiently low because banks must sell high-quality assets below their "fair" value. We consider whether equity injections and asset purchases improve market outcomes. By allowing banks to fund investments without selling high-quality assets, equity injections reduce the number of high-quality assets traded and further contaminate the interbank market. If equity is directed to firms with the greatest liquidity needs, the contamination effect causes investment to fall. Asset purchase programs often improve liquidity, investment and welfare.
    Keywords: Adverse selection; investment; TARP; financial crisis
    JEL: D53 E22 E44 D82 E6
    Date: 2010–06–22
  17. By: Philipp Denter; Dana Sisak
    Abstract: This paper studies the creation of property rights in a state of anarchy and in the presence of uncertainty about a potential appropriator's ability. In a game of conflict, securing property can be achieved by spending resources for protection. We show that secure property rights will never emerge in equilibrium. The reason for this finding is not that it is not possible to secure property in principle, but that because of uncertainty agents will choose to protect their possessions against an expected appropriator and not against the most able one. Hence, agents voluntarily expose themselves to the risk of losing ownership. This finding has important consequences, since secure property rights are a fundamental prerequisite of economic activity, and insecure property may for example hinder the exploitation of mutually beneficial trade opportunities or distort investment and production incentives.
    Keywords: Asymmetric Information, Property Rights, Conflict
    JEL: D02 D23 D74 D82
    Date: 2010–08

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