nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2011‒02‒05
eleven papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Renegotiation-Proof Contracts with Moral Hazard and Persistent Private Information By Bruno Strulovici
  2. Information Aggregation and Adverse Selection By Aristotelis Boukouras; Kostas Koufopoulos
  3. Information Disclosure in Procurement Auctions with Horizontally Di¤erentiated Suppliers By Domenico Colucci; Nicola Doni; Vincenzo Valori
  4. Efficient Search by Committee By Dirk Bergemann; Juuso Valimaki
  5. Contract Law and Development By Aristotelis Boukouras
  6. Kosher Pork By Allan Drazen; Ethan Ilzetzki
  7. Differences across originators in CMBS loan underwriting By Lamont K. Black; Chenghuan Sean Chu; Andrew Cohen; Joseph B. Nichols
  8. Verifying the state of financing constraints: evidence from U.S. business credit contracts By Ralf R. Meisenzahl
  9. Transparent Restrictions on Beliefs and Forward Induction Reasoning in Games with Asymmetric Information By Pierpaolo Battigalli; Andrea Prestipino
  10. Communication Equilibria and Bounded Rationality By Nikhil Vellodi
  11. Communicating Bailout Policy and Risk Taking in the Banking Industry By Jakob Bosma

  1. By: Bruno Strulovici
    Abstract: How does renegotiation affect contracts between a principal and an agent subject to persistent private information and moral hazard? This paper introduces a concept of renegotiation-proofness, which adapts to stochastic games the concepts of weak renegotiation-proofness and internal consistency by exploiting natural comparisons across states. When the agent has exponential utility and cost of effort, each separating renegotiation-proof contract is characterized by a single “sensitivity" parameter, which determines how the agent's promised utility varies with reported cash flows. The optimal contract among those always causes immiserization. Reducing the agent's cost of effort can harm the principal by increasing the tension between moral hazard and reporting problems. Truthfulness of the constructed contracts is obtained by allowing jumps in cash flow reports and turning the agent's reporting problem into an impulse control problem. This approach shows that self-correcting reports are optimal off the equilibrium path. The paper also discusses the case of partially pooling contracts and of permanent outside options for the agent, illustrating the interaction between cash-flow persistence, renegotiation, moral hazard, and information revelation.
    Keywords: Repeated Agency, Asymmetric Information, Persistent Information, Contract Theory, Principal Agent, Limited Commitment, Renegotiation, Recursive Contracts JEL Classification Numbers: D82, D86, C73, G30
    Date: 2011–01–20
  2. By: Aristotelis Boukouras (Georg-August-University Göttingen); Kostas Koufopoulos (University of Warwick)
    Abstract: We consider a general economy, where agents have private information about their types. Types can be multi-dimensional and potentially interdependent. We show that, if the interim distribution of types is common knowledge (the exact number of agents for each type is known), then a mechanism exists, which is consistent with truthful revelation of private information and which implements first-best allocations of resources as the unique Bayes-Nash equilibrium. Our result requires weak restrictions on preferences (Local Non-Common Indifference Property) and on the Pareto correspondence (Anonymity) and it is robust to small perturbations regarding the knowledge of the interim distribution. Our paper is useful in understanding the power of information aggregation in alleviating incentive constraints and is particularly pertinent to games with large populations, in which case the interim distribution of types converges to a unique distribution.
    Keywords: adverse selection; anonymity; first-best allocations; full implementation; information aggregation; mechanism design; single-crossing property; Pareto correspondence
    JEL: D71 D82 D86
    Date: 2011–01–20
  3. By: Domenico Colucci (Università degli Studi di Firenze,); Nicola Doni (Università degli Studi di Firenze, Dipartimento di Scienze Economiche); Vincenzo Valori (Università degli Studi di Firenze, Dipartimento di Matematica per le Decisioni)
    Abstract: This work studies a model of multidimensional auction in which a buyer needs to procure a given good from either of two potential suppliers whose quality is the buyer's private information and whose production costs are heterogeneous. Costs asymmetries constitute a novelty in this framework and extend e.g. the model of Gal-Or et al. (2007). We compare the outcomes of different procurement policies from the viewpoint of both efficiency and the buyer's payoff. A trade-off between efficiency and rent-extraction emerges. The buyer will maximize her expected utility by selecting a first score auction and either concealing or privately revealing suppliers'quality - the optimal choice depending on the degree of heterogeneity in suppliers' costs and qualities. However, neither of these auction mechanisms will be efficient: efficiency calls for a second score auction or a first score auction with public disclosure of suppliersquality. The findings hinge on the equivalence between auction models and models of horizontal differentiation and take advantage of results for asymmetric auctions developed by Maskin & Riley (2000).
    Keywords: multidimensional auctions, procurement policies, endogenous information, horizontal di¤erentiation, asymmetric auctions.
    JEL: D44 D82 H57
    Date: 2011
  4. By: Dirk Bergemann (Cowles Foundation, Yale University); Juuso Valimaki (Department of Economics, Aalto University School of Economics)
    Abstract: This note constructs an efficient mechanism for finding the best candidate for a committee from a sequence of potential candidates. Committee members have independent private values information about the quality of the candidate. The mechanism selects the best candidate according to the standard utilitarian welfare criterion. Furthermore, the mechanism can be modified to have a balanced budget.
    Keywords: Search, Committtees, Voting, Mechanism design, Dynamic pivot mechanism
    JEL: C72 D43 D82 D83 H41
    Date: 2011–01
  5. By: Aristotelis Boukouras (Georg-August-University Göttingen)
    Abstract: We relate the design of contract law to the process of development. In this paper, contract law defines which private agreements are enforceable (i.e. are binding and enforced by courts) and which are not. Specically, we consider an economy where agents face a hold-up problem (moral hazard in teams). The resulting time-inconsistency problem leads to inefficiently low levels of effort and trading among agents. The solution to this problem requires a social contract which meets two conditions: (i) an economywide delegate (judge) responsible for the enforcement of the social contract and (ii) a set of non-enforceable private contracts (regulation). However, because this mechanism is costly, its effectiveness depends on the aggregate production of the economy. To capture the interaction between contract enforcement and development, we introduce a multiperiod economy and show that, in the early stages of development, the mechanism is infeasible. The appearance of enforcement institutions and regulation is delayed for the later stages. At this point of time, the hold-up problem is solved and this spurs economic growth further. Finally, the relationship between economic development and the evolution of contract law may be non-monotonic, which may explain why empirical studies fail to find a robust relationship between the two.
    Keywords: contract law; development; enforcement institutions; hold-up; institutional agent; regulation; social contract
    JEL: D02 D82 D86 K12 O12 O31 O43
    Date: 2011–01–20
  6. By: Allan Drazen; Ethan Ilzetzki
    Abstract: Both conventional wisdom and leading academic research view pork barrel spending as antithetical to responsible policymaking in times of crisis. In this paper we present an alternative view. When agents are heterogeneous in their ideology and in their information about the economic situation, allocation of pork may enable passage of legislation appropriate to a "crisis" that might otherwise not pass. Pork "greases the legislative wheels" not by bribing legislators to accept legislation they view as harmful, but by conveying information about the necessity of policy change, where it may be impossible to convey such information in the absence of pork. Pork may be used for this function in situations where all legislators would agree to forgo pork under full information. Moreover, pork will be observed when the public good is most valuable precisely because it is valuable and the informed agenda setter wants to convey this information.
    JEL: D72 E62 H40
    Date: 2010
  7. By: Lamont K. Black; Chenghuan Sean Chu; Andrew Cohen; Joseph B. Nichols
    Abstract: Differences in the organizational structure of CMBS loan originators may reflect differences in the incentives they face for underwriting risky loans. We treat an originator's type--that is, commercial bank, investment bank, insurance company, finance company, conduit lender, or foreign-owned entity--as a proxy for incentives related to warehousing risk, balance sheet lending, and regulatory constraints. After controlling for observable credit characteristics of over 30,000 loans securitized into CMBS after 1999, we find considerable differences in loan performance across originator types. The results suggest that moral hazard--captured by lack of warehousing risk-negatively affected the quality of loans underwritten by conduit lenders. On the other hand, despite opportunities for adverse selection, balance sheet lenders--commercial banks, insurance companies and finance companies--actually underwrote higher quality loans.
    Date: 2011
  8. By: Ralf R. Meisenzahl
    Abstract: Which of the strategies for financing constraints in economic models is the most empirically plausible? This paper tests two commonly used models of financing constraints, costly state verification (Townsend, 1979) and moral hazard (Holmstrom and Tirole, 1997), using a comprehensive data set of US small business credit contracts. The data include detailed information about the business, its owner, bank balance sheet information, and the terms of credit. In line with the predictions of models of financing constraints, I find that an additional dollar of net worth accounts for about 30 cents of external finance. More than two thirds of the business credit contracts can be rationalized by one period debt contracts with costly state verification. The parameter values obtained in the costly state verification model imply bankruptcy costs of 28% of expected output and a rate of return ranging between 5% and 8% annually, which are consistent with studies on bankruptcy incidences and returns to entrepreneurial investment. The moral hazard model, however, performs poorly. The correlation between model implied interest rates and actual interest rates paid is close to zero because the bank variables emphasized by this model do not explain loan interest rates.
    Date: 2011
  9. By: Pierpaolo Battigalli; Andrea Prestipino
    Abstract: We analyze forward-induction reasoning in games with asymmetric information under the assumption that some given restrictions ? on players’initial or conditional first-order beliefs are "transparent", that is, not only the restrictions ? hold, but there is common belief in ? at every node. Most applied models of asymmetric information are covered as special cases whereby ? pins down the probabilities initially assigned to states of nature. But the abstract analysis also allows for transparent restrictions on beliefs about behavior, e.g. independence restrictions or restrictions induced by the context behind the game. Our contribution is twofold. First, we study the differences and similarities between two versions of extensive- form rationalizability incorporating such restrictions: strong ?-rationalizability (Battigalli [3, 1999], [4, 2003]) and ?-rationalizability (Battigalli-Siniscalchi [11, 2003]). Second, we provide an epistemic characterization for the former solution concept, showing that it is the conceptually correct one. This is compared with an alternative characterization due to Battigalli-Siniscalchi [12, 2007] whereby the ?-restrictions are not assumed to be transparent, but rather to have the same "epistemic priority" as the rationality assumption.
    Date: 2011
  10. By: Nikhil Vellodi (University of Warwick)
    Abstract: In this paper, we generalize the notion of a communication equilibrium (Forges 1986, Myerson 1986) of a game with incomplete information by introducing two new types of correlation device, namely extended and Bayesian devices. These new devices explicitly model the `thinking process' of the device, i.e. the manner in which it generates outputs conditional on inputs. We proceed to endow these devices with both information processing errors, in the form of non-partitional information, and multiple transition and prior distributions, and prove that these two properties are equivalent in this context, thereby generalizing the result of Brandenburger, Dekel and Geanakoplos (1988). We proceed to discuss the Revelation Principle for each device, and conclude by nesting a certain class of `cheap-talk' equilibria of the underlying game within Bayesian communication equilibria. These so-called fallible talk equilibria cannot be generated by standard communication equilibria.
    Date: 2010
  11. By: Jakob Bosma
    Abstract: This paper considers the effects of imperfectly communicated information about whether a regulator initiates a bailout program for financially distressed banks. The theoretical framework allows for determining whether, and to what extent, it is optimal for a regulator to be imprecise in communicating its bank bailout strategy. Banks do not only rely on their prediction of the regulator’s action, but also on their beliefs about other banks’ predictions to infer the regulator’s strategy. Results indicate that the regulator may substitute higher capital adequacy requirements for being less precise in communicating whether to initiate a bailout program to maintain risk taking by banks.
    Keywords: bank bailout support; noisy communication; regulation; risk taking
    JEL: D82 L51
    Date: 2011–01

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