nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2011‒04‒02
twelve papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Dynamic Adverse Selection and the Size of the Informed Side of the Market By Ennio Bilancini; Leonardo Boncinelli
  2. Repeated moral hazard and contracts with memory: A laboratory experiment By Nieken, Petra; Schmitz, Patrick W
  3. Higher Order Expectations, Illiquidity, and Short-term Trading By Cespa, Giovanni; Vives, Xavier
  4. Preventing Collusion through Discretion By Felli, Leonardo; Hortala-Vallve, Rafael
  5. Procurement under default risk: auctions or lotteries? By Ottorino Chillemi; Claudio Mezzetti
  6. Liquidity hoarding By Douglas Gale; Tanju Yorulmazer
  7. Sanctions that Signal: an Experiment. By Roberto Galbiati; Karl Schlag; Joel van der Weele
  8. Substitution or complementarity between Information “soft” and information “hard”: why and which effect on bank profitability? By Herve Alexandre; Aymen Smondel
  9. Signaling, Learning and Screening Prior to Trial: Informational Implications of Preliminary Injunctions By Thomas D. Jeitschko; Byung-Cheol Kim
  10. The Effects of Collateral on Firm Performance By Ono, Arito; Sakai, Koji; Uesugi、Iichiro
  11. Forward Induction in Arms Races By L. Lambertini
  12. Recursive methods for incentive problems By Matthias Messner; Nicola Pavoni; Christopher Sleet

  1. By: Ennio Bilancini; Leonardo Boncinelli
    Abstract: In this paper we examine the problem of dynamic adverse selection in a stylized market where the quality of goods is a seller’s private information. We show that in equilibrium all goods can be traded if a simple piece of information is made publicly available: the size of the informed side of the market. Moreover, we show that if exchanges can take place frequently enough, then agents roughly enjoy the entire potential surplus from exchanges. We illustrate these findings with a dynamic model of trade where buyers and sellers repeatedly interact over time. More precisely we prove that, if the size of the informed side of the market is a public information at each trading stage, then there exists a weak perfect Bayesian equilibrium where all goods are sold in finite time and where the price and quality of traded goods are increasing over time. Moreover, we show that as the time between exchanges becomes arbitrarily small, full trade still obtains in finite time – i.e., all goods are actually traded in equilibrium – while total surplus from exchanges converges to the entire potential. These results suggest two policy interventions in markets suffering from dynamic adverse selection: first, the public disclosure of the size of the informed side of the market in each trading stage and, second, the increase of the frequency of trading stages.
    Keywords: dynamic adverse selection; full trade; size of the informed side; frequency of exchanges; asymmetric information
    JEL: D82 L15
    Date: 2011–03
  2. By: Nieken, Petra; Schmitz, Patrick W
    Abstract: This paper reports data from a laboratory experiment on two-period moral hazard problems. The findings corroborate the contract-theoretic insight that even though the periods are technologically unrelated, due to incentive considerations principals may prefer to offer contracts with memory.
    Keywords: Laboratory experiment; Repeated moral hazard; Sequential hidden actions
    JEL: D82 J33
    Date: 2011–02
  3. By: Cespa, Giovanni; Vives, Xavier
    Abstract: We propose a theory that jointly accounts for an asset illiquidity and for the asset price potential over-reliance on public information. We argue that, when trading frequencies differ across traders, asset prices reflect investors' Higher Order Expectations (HOEs) about the two factors that influence the aggregate demand: fundamentals information and liquidity trades. We show that it is precisely when asset prices are driven by investors' HOEs about fundamentals that they over-rely on public information, the market displays high illiquidity, and low volume of informational trading; conversely, when HOEs about fundamentals are subdued, prices under-rely on public information, the market hovers in a high liquidity state, and the volume of informational trading is high. Over-reliance on public information results from investors' under-reaction to their private signals which, in turn, dampens uncertainty reduction over liquidation prices, favoring an increase in price risk and illiquidity. Therefore, a highly illiquid market implies higher expected returns from contrarian strategies. Equivalently, illiquidity arises as a byproduct of the lack of participation of informed investors in their capacity of liquidity suppliers, a feature that appears to capture some aspects of the recent crisis.
    Keywords: Average expectations; Beauty Contest; Expected returns; Multiple equilibria; Over-reliance on public information
    JEL: G10 G12 G14
    Date: 2011–03
  4. By: Felli, Leonardo; Hortala-Vallve, Rafael
    Abstract: Large public bureaucracies are commonly regarded as less efficient than modern private corporations. This paper explores how the degree of discretionary power might account for this difference in efficiency. Indeed, increasing the discretionary power of the intermediate layers of an organization - delegating power to them - enhances productivity by preventing collusion and capture between middle managers and line workers; provided that this detrimental form of collusion takes place in conditions of asymmetric information. To understand how this mechanism works requires an explicit model of the penalty for breach of a collusive agreement a party has to incur to walk away from such a side deal. Delegation is then a simple way for the principal to compensate the uninformed colluding party for walking out of collusion and for using/reporting the information leaked in the collusive negotiation. This threat clearly reduces the informed party incentive to participate in side deals and prevents collusion at a reduced cost.
    Keywords: Collusion; Communication; Delegation; Hierarchies
    JEL: D73 D78 D83
    Date: 2011–03
  5. By: Ottorino Chillemi (University of Padova); Claudio Mezzetti (University of Warwick)
    Abstract: We study optimal procurement in the presence of default risk. Contractors differ in the penalty they suffer in case of default, which is private information. If the loss to the procurer from non-completion is high relative to the cost of completion, the optimal mechanism is to assign the project by a fair lottery. The procurer pays the winner enough so that the project is always completed and extracts contractors' surplus by charging them participation fees. When the loss to the procurer from non-completion is low relative to the cost of completion, the project is assigned to the contractor with the highest probability of default; that is, the one with the lowest defaulting penalty. The optimal probability of default is inefficiently low: projects that would be first-best efficient not to complete are completed.
    Keywords: procurement, auctions, abnormally low tender, default risk.
    JEL: D44 D82 H57 L51
    Date: 2011–03
  6. By: Douglas Gale; Tanju Yorulmazer
    Abstract: Banks hold liquid and illiquid assets. An illiquid bank that receives a liquidity shock sells assets to liquid banks in exchange for cash. We characterize the constrained efficient allocation as the solution to a planner’s problem and show that the market equilibrium is constrained inefficient, with too little liquidity and inefficient hoarding. Our model features a precautionary as well as a speculative motive for hoarding liquidity, but the inefficiency of liquidity provision can be traced to the incompleteness of markets (due to private information) and the increased price volatility that results from trading assets for cash.
    Keywords: Bank liquidity ; Bank assets ; Interbank market
    Date: 2011
  7. By: Roberto Galbiati; Karl Schlag; Joel van der Weele
    Abstract: Sanctions are a means to provide incentives towards more pro-social behavior. Yet their implementation can be a signal that past behavior was undesirable. We investigate experimentally the importance of the informational content of the choice to sanction. We place this in a context of a coordination game to focus attention on beliefs and information and less on intrinsic or pro-social motivations. We compare the eect of sanctions that are introduced exogenously by the experimenter to that of sanctions which have been actively chosen by a subject who takes the role of a fictitious policy maker with superior information about the previous eort of the other players. We nd that cooperative subjects perceive actively chosen sanctions as a negative signal which eliminates for them the incentive eect of sanctions.
    JEL: C92 D83 K42
    Date: 2011–03
  8. By: Herve Alexandre (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris Dauphine - Paris IX); Aymen Smondel (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris Dauphine - Paris IX)
    Abstract: The Basel II committee set up directives encouraging banks to use internal scores in order to assess the risk of their customers. This new form of information competes with the existing ones. SMEs are most concerned by these new stakes, due to the lack of transparency. The aim of this paper is to understand the determinants of the choice between substitution and complementarity between the two types of information: “soft” and “hard”, to test a potential effect of this choice on the banking performance and to describe which variables are involved in the decision-making process. The originality of this work is to try to quantify the information costs and to use it as a variable which is affecting the adopted choice.
    Keywords: Basel directives, “soft” information, “hard” information, credit decision-making process, bank performance, Bank-SMEs relationship.
    Date: 2010–06–25
  9. By: Thomas D. Jeitschko (Economic Analysis Group, Antitrust Division, U.S. Department of Justice); Byung-Cheol Kim
    Abstract: The decision to request a preliminary injunction—a court order that bans a party from certain actions until their lawfulness are ascertained in a final court ruling at trial—is an important litigation instrument in many areas of the law including antitrust, copyright, patents, trademarks, employment and labor relations as well as contracts. The process of filing for a preliminary injunction and the court's ruling on such a request generates information that can affect possible settlement decisions. We consider these implications when there is uncertainty about both the plaintiff's damages as well as the merits of case in the eyes of the court. Both plaintiff and defendant revise their beliefs about the case strength in dispute once they observe the court's ruling on preliminary injunctive relief. We study how such learning affects the likelihood of settlement. A precursor to this analysis is the study of the strategic role of preliminary injunctions as a means to signal the plaintiff's willingness to settle.
    Keywords: preliminary injunction, learning, signaling, screening, litigation, pre-trial motion, settlement
    JEL: D8 K12 K21 K41 J53 L4
    Date: 2011–02
  10. By: Ono, Arito; Sakai, Koji; Uesugi、Iichiro
    Abstract: This paper examines how collateral and personal guarantees affect firms’ ex-post performance employing a propensity score matching estimation approach. Based on a unique firm-level panel data set of more than 500 small-and-medium-sized borrower firms in Japan, we find that borrowers that provide collateral to lenders experience larger increases in profitability and reductions in riskiness than borrowers that do not. The main channel through which the borrower enhances its profitability is cost-cutting restructuring. These findings are consistent with the hypothesis that collateral reduces moral hazard by providing borrowers with an incentive to enhance their creditworthiness. We find little evidence that improvements in collateralized firms’ performance are driven by the intensified monitoring on the part of lenders, or by borrowing firms’ access to larger amounts of credit.
    Keywords: collateral, moral hazard, propensity score
    JEL: D82 G21 G30
    Date: 2011–02
  11. By: L. Lambertini
    Abstract: I investigate a two-country non cooperative game where the status quo ante is asymmetric as one country is endowed with nuclear weapons while the other is not and is evaluating the opportunity of build up a nuclear arsenal. After identifying the conditions on payoffs such that the resulting reduced form is a coordination game with two symmetric equilibria, I resort to forward induction to show that the implicit signalling mechanism in it may lead countries to select the peaceful equilibrium in a symmetric environment where both are endowed with analogous arsenals
    JEL: C72 F50
    Date: 2011–03
  12. By: Matthias Messner; Nicola Pavoni; Christopher Sleet
    Abstract: Many separable dynamic incentive problems have primal recursive formulations in which utility promises serve as state variables. We associate families of dual recursive problems with these by selectively dualizing constraints. We make transparent the connections between recursive primal and dual approaches, relate value iteration under each and give conditions for it to be convergent to the true value function.
    Date: 2011

This nep-cta issue is ©2011 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.
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