nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2010‒11‒20
twelve papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Binary Payment Schemes: Moral Hazard and Loss Aversion By Fabian Herweg; Daniel Müller; Philipp Weinschenk
  2. Moral Hazard and Ambiguity By Philipp Weinschenk
  3. Clients, Lawyers, Second Opinions, and Agency By Andrew F. Daughtey; Jennifer F. Reinganum
  4. Sending Information to Interactive Receivers Playing a Generalized Prisoners Dilemma By Kfir Eliaz; Roberto Serrano
  5. Social Networks and Unraveling in Labor Markets By Itay Fainmesser
  6. Community Structure and Market Outcomes: A Repeated Games in Networks Approach By Itay Fainmesser
  7. Central bank communication: fragmentation as an engine for limiting the publicity degree of information By Trabelsi, Emna
  8. How Optimism Leads to Price Discovery and Efficiency in a Dynamic Matching Market By Dipjyoti Majumdar; Artyom Shneyerov; Huan Xie
  9. Do Investors Trust or Simply Gamble? By Roman Sheremeta; Timothy Shields
  10. Too Much Information Sharing? Welfare Effects of Sharing Acquired Cost Information in Oligopoly By Juan José Ganuza; Jos Jansen
  11. The Effect of Entitlements and Equality on Cooperative Bargaining with Private, Unverifiable Information By Christopher Bruce; Jeremy Clark
  12. International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions By Alberto Martin; Filippo Taddei

  1. By: Fabian Herweg (University of Bonn); Daniel Müller (University of Bonn); Philipp Weinschenk (Max Planck Institute for Research on Collective Goods)
    Abstract: We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to Köszegi and Rabin (2006, 2007). The optimal contract is a binary payment scheme even for a rich performance measure, where standard preferences predict a fully contingent contract. The logic is that, due to the stochastic reference point, increasing the number of different wages reduces the agent’s expected utility without providing strong additional incentives. Moreover, for diminutive occurrence probabilities for all signals the agent is rewarded with the fixed bonus if his performance exceeds a certain threshold.
    JEL: D82 M12 M52
    Date: 2010–09
  2. By: Philipp Weinschenk (Max Planck Institute for Research on Collective Goods)
    Abstract: We consider a principal-agent model with moral hazard where the agent’s knowledge about the performance measure is ambiguous and he is averse towards ambiguity. We show that the principal may optimally provide no incentives or contract only on a subset of all informative performance measures. That is, the Informativeness Principle does not hold in our model. These results stand in stark contrast to the ones of the orthodox theory, but are empirically of high relevance.
    Keywords: financial crisis, Basel Accord, banking regulation, capital requirements, modelbased approach, systemic risk
    JEL: D82 M12 M52
    Date: 2010–09
  3. By: Andrew F. Daughtey (Department of Economics and Law School, Vanderbilt University); Jennifer F. Reinganum (Department of Economics and Law School, Vanderbilt University)
    Abstract: We model the game between an informed seller (a lawyer) and an uninformed buyer (a potential client) over the choice of compensation for the lawyer to take a case to trial, when there is post-contracting investment by the lawyer (effort at trial) that involves moral hazard. Clients incur a one-time search cost to contact a lawyer, which parametrically influences the monopoly power of the lawyer when he makes a demand of the client for compensation for his service. The client uses the demand to decide whether to contract with the lawyer or to visit a second lawyer so as to seek a second opinion, which incurs a second search cost. Seeking a second opinion shifts the bargaining power to the client by causing the lawyers to bid for the right to represent the client. We allow for endogenously-determined contingent fees alone (that is, the lawyer covers all costs and obtains a percentage of any amount won at trial) or endogenously-determined contingent fees and transfers; in this latter analysis, lawyers could buy the client’s case. Under asymmetric information with only a contingent fee, in equilibrium the first lawyer visited demands a higher contingent fee for lower-valued cases, signaling the case’s value to the client. If a transfer is also allowed, then in equilibrium the higher contingent fee (and transfer from the lawyer to the client) is obtained by the more valuable case, with only the highest-value case resulting in the lawyer buying the entire case (100% contingent fee with a transfer); again, in equilibrium, the value of the case is signaled. In both settings the client uses an equilibrium strategy that involves seeking a second opinion a fraction of the time, which induces separation. In equilibrium the presence of asymmetric information does not affect the client’s expected payoff, but it does reduce the lawyer’s expected payoff and it does increase moral-hazard-induced inefficiency on the part of the lawyer in the post-contracting investment.
    Keywords: Signaling, Agency, Search, Contingent Fee
    JEL: D8 K4 L2
    Date: 2010–06
  4. By: Kfir Eliaz; Roberto Serrano
    Abstract: Consider the problem of information disclosure for a planner who faces two agents interacting in a state-dependent multi-action prisoners?dilemma. We ?nd conditions under which the planner can make use of his superior information by disclosing some of it to the agents, and conditions under which such information leakage is not possible. Although the problem is entirely symmetric, the planner?s only way to reveal part of the information is based on creating asymmetries between the two agents by giving them di¤erent pieces of information. We also ? nd conditions under which such partially informative equilibria are the planner?s best equilibria.
    Keywords: Information Disclosure; Generalized Prisoners Dilemma; Uninformative Equilibria; Partially or Fully Informative Equilibria
    Date: 2010
  5. By: Itay Fainmesser
    Abstract: This paper studies the phenomenon of early hiring in entry-level labor markets (e.g. the market for gastroenterology fellowships and the market for judicial clerks) in the presence of social networks. We o¤er a two-stage model in which workers in training institutions reveal information on their own ability over time. In the early stage, workers receive a noisy signal about their own ability. The early information is ?soft?and non-veri?able, and workers can convey the information credibly only to ? rms that are connected to them (potentially via their mentors). At the second stage, ? hard? veri?able (and accurate) information is revealed to the workers and can be credibly transmitted to all ?rms. We characterize the e¤ects of changes to the network structure on the unraveling of the market towards early hiring. Moreover, we show that an e¢ cient design of the matching procedure can prevent unraveling.
    Keywords: Networks; market design; unraveling; entry-level labor markets; early hiring
    Date: 2010
  6. By: Itay Fainmesser
    Abstract: Consider a large market with asymmetric information, in which sellers choose whether to cooperate or deviate and ?cheat?their buyers, and buyers decide whether to re-purchase from di¤erent sellers. We model active trade relationships as links in a buyer-seller network and suggest a framework for studying repeated games in such networks. In our framework, buyers and sellers have rich yet incomplete knowledge of the network structure; allowing us to derive meaningful conditions that determine whether a network is consistent with trade and cooperation between every buyer and seller that are connected. We show that three network features reduce the minimal discount factor necessary for sustaining cooperation: moderate competition, sparseness, and segregation. We ? nd that the incentive constraints rule out networks that maximize the volume of trade and that the constrained trade maximizing networks are in between ?old world? segregated and sparse networks, and a ?global market?
    Keywords: Buyer-Seller networks; repeated games; moral hazard;asymmetric information; trust; cooperation; institutions
    Date: 2010
  7. By: Trabelsi, Emna
    Abstract: In earlier theoretical framework, Morris and Shin (2002) highlight the potential dangers of transparency policy. In particular, public announcements may be detrimental to social welfare. Later, Morris and Shin (2005) uphold that more precise communication can degrade the signal value of prices. Researchers suggest reducing the precision of public information or withholding it. Cornand and Heinemann (2008) suggest rather limiting the publicity degree. We found that the same effect can be reached by establishing fragmented public information, but in presence of private signal.
    Keywords: transparency ; central bank communication ; semi public information ; private information ; coordination
    JEL: E58 D83 D82
    Date: 2010–11–05
  8. By: Dipjyoti Majumdar (Concordia University); Artyom Shneyerov (Concordia University); Huan Xie (Concordia University)
    Abstract: We study a market search equilibrium with aggregate uncertainty, private information and heterogeneus beiefs. Traders initially start out optimistic and then update their beliefs based on their matching experience in the market, using the Bayes rule. It is shown that all separating equilibria converge to perfect competition in the limit as the time between matches tends to 0. We also establish existence of a separating equilibrium.
    Keywords: Markets with search frictions, aggregate uncertainty, heterogeneous beliefs, optimism, bargaining, foundations of Walrasian equilibrium
    JEL: C73 C78 D83
    Date: 2010–10–22
  9. By: Roman Sheremeta (Argyros School of Business and Economics, Chapman University); Timothy Shields (Argyros School of Business and Economics, Chapman University)
    Abstract: We design an experiment to study individual behavior in a strategic information setting where the sender has economic incentives to deceive and the receiver has economic incentives to avoid deception. To ascertain whether subjects in the role of receiver glean information content from the sender’s message, we elicit choices from risky gambles constructed to be mathematically equivalent to the information setting if the sender’s message lacks information content. In the experiment subjects act simultaneously as a sender and receiver in a one-shot interaction. The findings of our experiment indicate that (i) subjects tend to act deceptively as senders but trusting as receivers, and (ii) as receivers, subjects glean information content from the senders’ messages. Thus, we find investors (receivers) trust and investment cannot be rationalized solely by subjects’ attitudes towards risk.
    Keywords: experiment, level-k thinking, strategic communication, risk preference, beliefs
    Date: 2010
  10. By: Juan José Ganuza (Universitat Pompeu Fabra, Department of Economics and Business); Jos Jansen (Max Planck Institute for Research on Collective Goods)
    Abstract: By using general information structures and precision criteria based on the dispersion of conditional expectations, we study how oligopolists’ information acquisition decisions may change the effects of information sharing on the consumer surplus. Sharing information about individual cost parameters gives the following trade-off in Cournot oligopoly. On the one hand, it decreases the expected consumer surplus for a given information precision, as the literature shows. On the other hand, information sharing increases the firms’ incentives to acquire information, and the consumer surplus increases in the precision of the firms’ information. Interestingly, the latter effect may dominate the former effect.
    Keywords: Oligopoly, information acquisition, information sharing, Information structures, Consumer surplus
    JEL: D82 L13 L40 D83
    Date: 2010–09
  11. By: Christopher Bruce; Jeremy Clark (University of Canterbury)
    Abstract: In many bargaining situations a third party is authorized to impose a backstop position on the bargainers. Prominent examples include governments who use collaborative policymaking between stakeholders to set public policy, but also compulsory arbitration in labour negotiations. Axiomatic models of cooperative bargaining, such as the Nash bargain, presume that the status quo allocation will have no effect on the outcome parties reach if it differs from the backstop set by the third party. In contrast, experimental findings have suggested that both equality of outcomes and entitlement (where the status quo establishes a focal point) may affect the agreements bargainers reach, at least under full information. This paper extends the investigation of the effect of equality and entitlement on cooperative bargaining to the case where parties have private, unverifiable information concerning the value of outcomes. We use a two-party, two-attribute experimental design in which subjects take part in unstructured, face-to-face bargaining to jointly select from among approximately 200 potential outcomes. We find that, relative to full information, parties who bargain under private information are almost as likely to reach agreements as those under full information, and that these agreements are still approximately Pareto efficient. Further, the effect of the status quo (rather than backstop) allocation seems amplified under private information, while the effect of equality is dampened, but not eliminated.
    Keywords: cooperative bargaining; private information; Nash bargain; egalitarian; entitlement; fairness; focal points
    JEL: C92 D74 H44 Q58
    Date: 2010–11–04
  12. By: Alberto Martin; Filippo Taddei
    Abstract: The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial frictions, however, which have focused almost exclusively on the effects of limited pledgeability. In this paper, we fill this gap by developing a standard growth model with adverse selection. Our main results are that, by fostering unproductive investment, adverse selection: (i) leads to an increase in the economy's equilibrium interest rate, and (ii) it generates a negative wedge between the marginal return to investment and the equilibrium interest rate. Under financial integration, we show how this translates into excessive capital inflows and endogenous cycles. We also explore how these results change when limited pledgeability is added to the model. We conclude that both frictions complement one another and argue that limited pledgeability exacerbates the effects of adverse selection.
    Keywords: Limited Pledgeability; Asymmetric Information; International Capital Flows; Credit Market Imperfections
    JEL: D53 D82 E22 F34
    Date: 2010

This nep-cta issue is ©2010 by Simona Fabrizi. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.