nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2011‒05‒14
twenty-one papers chosen by
Simona Fabrizi
Massey University, Albany

  1. A Model of Optimal Government Bailouts By Bernardo, Antonio; Talley, Eric; Welch, Ivo
  2. A Theory of BOT Concession Contracts By Auriol, Emmanuelle; Picard, Pierre
  3. Nested potentials and robust equilibria By UNO, Hiroshi
  4. Quantum Bayesian implementation and revelation principle By Wu, Haoyang
  5. Dark Pool Trading Strategies By Sabrina Buti; Barbara Rindi; Ingrid M. Werner
  6. Competition and Relational Contracts: The Role of Unemployment as a Disciplinary Device By Martin Brown; Armin Falk; Ernst Fehr
  7. Incentives and the Delegation of Decision Making Power in Sovereign Wealth Funds By Artur Grigoryan
  8. Optimal Coexistence of Long-term and Short-term contracts in Labor Markets By Inés Macho-Stadler; David Pérez-Castrillo; Nicolás Porteiro
  9. Revenue Comparison in Asymmetric Auctions with Discrete Valuations By Nicola Doni; Domenico Menicucci
  10. The Social Cost of Near-Rational Investment By Tarek A. Hassan; Thomas M. Mertens
  11. Incentives through the cycle: microfounded macroprudential regulation By di Iasio, Giovanni; Quagliariello, Mario
  12. Managing Self-Confidence: Theory and Experimental Evidence By Markus M. Mobius; Muriel Niederle; Paul Niehaus; Tanya S. Rosenblat
  13. Containing Systemic Risk: Paradigm-Based Perspectives on Regulatory Reform By Augusto de la Torre; Alain Ize
  14. Flexible Wage Contracts, Temporary Jobs and Worker Performance: Evidence from Italian Firms By Michele Battisti; Giovanna Vallanti
  15. Institutions and Contract Enforcement By Armin Falk; David Huffman; W. Bentley Macleod
  16. What drives taxi drivers? A field experiment on fraud in a market for credence goods By Loukas Balafoutas; Adrian Beck; Rudolf Kerschbamer; Matthias Sutter
  17. Monitoring and Pay: An Experiment on Employee Performance under Endogenous Supervision By Dittrich, Dennis A. V.; Kocher, Martin G.
  18. The Sequencing Problem in Sequential Investigation Processes By Jürgen-Peter Kretschmer
  19. Hazardous Activities and Civil Strict Liability: The Regulator’s Dilemma By Gérard Mondello
  20. Optimal Taxation with Rent-Seeking By Casey Rothschild; Florian Scheuer
  21. Do Combinatorial Procurement Auctions Lower Cost? - An Empirical Analysis of Public Procurement of Multiple Contracts By Lunander, Anders; Lundberg, Sofia

  1. By: Bernardo, Antonio; Talley, Eric; Welch, Ivo
    Abstract: We analyze incentive-efficient government bailouts within a canonical model of intra-firm moral hazard. Bailouts exacerbate the moral hazard of firms and managers in two ways. First, they make them less averse to failing. Second, the taxes to fund bailouts dampen their incentives. Nevertheless, if third-party externalities from keeping the firm alive are strong, bailouts can improve welfare. Our model suggests that governments should use bailouts sparingly, where social externalities are large and subsidies small; eliminate incumbent owners and managers to improve a priori incentives; and finance bailouts through redistributive taxes on productive firms instead of forcing recipients to repay in the future.
    Keywords: Government Bailout, Moral Hazard, Law
    Date: 2011–03–03
  2. By: Auriol, Emmanuelle (TSE, ARQADE and IDEI); Picard, Pierre (CREA, University of Luxembourg and CORE, Université Catholique de Louvain)
    Abstract: In this paper, we discuss the choice for build-operate-and-transfer (BOT) concessions when governments and …rm managers do not share the same information regarding the operation characteristics of a facility. We show that larger shadow costs of public funds and larger information asymmetries entice governments to choose BOT concessions. This result stems from a trade-o¤ between the governments shadow costs of …nancing the construction and the operation of the facility and the excessive usage price that the consumer may face during the concession period. The incentives to choose BOT concessions increase as a function of ex-ante informational asymmetries between governments and potential BOT concession holders and with the possibility of transferring the concession cost characteristics to public …rms at the termination of the concession.
    Keywords: Public-private-partnership, privatization, adverse selection, regulation, natural monopoly, infrastructure, facilities
    JEL: L43 L51 D83 L33
    Date: 2011–03–25
  3. By: UNO, Hiroshi (Université catholique de Louvain, CORE, B-1348 Louvain-la-Neuve, Belgium)
    Abstract: This paper introduces the notion of nested best-response potentials for complete in- formation games. It is shown that a unique maximizer of such a potential is a Nash equilibrium that is robust to incomplete information in the sense of Kajii and Morris (1997, mimeo).
    Keywords: incomplete information, potential games, robustness, refinements
    JEL: C72 C73
    Date: 2011–02–01
  4. By: Wu, Haoyang
    Abstract: Bayesian implementation concerns decision making problems when agents have incomplete information. This paper proposes that the traditional sufficient conditions for Bayesian implementation shall be amended by virtue of a quantum Bayesian mechanism. In addition, by using an algorithmic Bayesian mechanism, this amendment holds in the macro world. More importantly, we find that the revelation principle is not always right by using the quantum and algorithmic Bayesian mechanisms.
    Keywords: Quantum game theory; Mechanism design; Bayesian implementation; Revelation principle.
    JEL: D71 D80 C72
    Date: 2011–04–28
  5. By: Sabrina Buti; Barbara Rindi; Ingrid M. Werner
    Abstract: We model a dynamic financial market where traders submit orders either to a limit order book (LOB) or to a Dark Pool (DP). We show that there is a positive liquidity externality in the DP, that orders migrate from the LOB to the DP, but that overall trading volume increases when a DP is introduced. We also demonstrate that DP market share is higher when LOB depth is high, when LOB spread is narrow, when the tick size is large and when traders seek protection from price impact. Further, while inside quoted depth in the LOB always decreases when a DP is introduced, quoted spreads can narrow for liquid stocks and widen for illiquid ones. We also show that traders? interaction with both LOB and DP generates interesting systematic patterns in order ?ow: di¤erently from Parlour (1998), the probability of a continuation is greater than that of a reversal only for liquid stocks. In addition, when depth decreases on one side of LOB, liquidity is drained from DP. When a DP is added to a LOB, total welfare as well as institutional traders' welfare increase but only for liquid stocks; retail traders'welfare instead always decreases. Finally, when flash orders provide select traders with information about the state of the DP, we show that more orders migrate from the LOB to the DP, and DP welfare e¤ects are enhanced.
    Date: 2011
  6. By: Martin Brown (Swiss National Bank and CenTER Tilburg University); Armin Falk (University of Bonn); Ernst Fehr (Institute for Empirical Research in Economics, University of Zurich)
    Abstract: When workers are faced with the threat of unemployment, their relationship with a particular firm becomes valuable. As a result, a worker may comply with the terms of a relational contract that demands high effort even when performance is not enforceable by a third party. But can relational contracts motivate high effort when workers can easily find alternative jobs? We examine how competition for labor affects the emergence of relational contracts and their effectiveness in overcoming moral hazard in the labor market. We show that effective relational contracts do emerge in a market with excess demand for labor. Long-term relationships turn out to be less frequent when there is excess demand for labor than they are in a market characterized by exogenous unemployment. However, stronger competition for labor does not impair labor market efficiency: higher wages induced by competition lead to higher effort out of concerns for reciprocity.
    Keywords: Relational Contracts, Involuntary Unemployment
    JEL: D82 J3 J41 E24 C9
    Date: 2011–05
  7. By: Artur Grigoryan (University of Siegen)
    Abstract: The paper models the incentives of a politician to delegate the decision making power in a sovereign wealth fund to an independent external manager. It formalizes the learning-e¤ects as well as the increase of transparency of the SWF and the rise of investment possibilities associated with higher transparency. It also focuses on the role of elections as a basic mechanism to control and discipline politicians. I show that the politician has incentives for strategic behaviour if voters have incomplete information about his competence. The paper also studies when the delegation of decision making power is socially optimal and under which circumstances it takes place.
    Keywords: DSovereign Wealth Fund (SWF), Transparency, Policy Delegation, External Management
    JEL: D7 E6 F3 G2
    Date: 2011
  8. By: Inés Macho-Stadler; David Pérez-Castrillo; Nicolás Porteiro
    Abstract: We consider a market where firms hire workers to run their projects and such projects differ in profitability. At any period, each firm needs two workers to suc- cessfully run its project: a junior agent, with no specific skills, and a senior worker, whose effort is not verifiable. Senior workers differ in ability and their competence is revealed after they have worked as juniors in the market. We study the length of the contractual relationships between firms and workers in an environment where the matching between firms and workers is the result of market interaction. We show that, despite in a one-firm-one-worker set-up long-term contracts are the op- timal choice for firms, market forces often induce firms to use short-term contracts. Unless the market only consists of firms with very profitable projects, firms oper- ating highly profitable projects offer short-term contracts to ensure the service of high-ability workers and those with less lucrative projects also use short-term contracts to save on the junior workers' wage. Intermediate firms may (or may not) hire workers through long-term contracts.
    JEL: D86 C78
    Date: 2011–05–05
  9. By: Nicola Doni (Università degli Studi di Firenze,); Domenico Menicucci (Dipartimento di Matematica per le Decisioni)
    Abstract: We consider an asymmetric auction setting with two bidders such that the valuation of each bidder has a binary support. We prove that in this context the second price auction yields a higher expected revenue than the first price auction for a broad set of parameter values, although the opposite result is common in the literature on asymmetric auctions. For instance, the second price auction is superior both when a bidder’s valuation is more uncertain that the valuation of the other bidder, and in case of a not too large distribution shift or rescaling. In addition, we show that in some cases the revenue in the first price auction decreases when all the valuations increase [in doing so, we correct a claim in Maskin and Riley (1985), and we derive the bidders’ preferences between the two auctions.
    Keywords: Asymmetric auctions, First price auctions, Second price auctions.
    JEL: D44 D82
    Date: 2011
  10. By: Tarek A. Hassan; Thomas M. Mertens
    Abstract: We show that the stock market may fail to aggregate information even if it appears to be efficient and that the resulting decrease in the information content of stock prices may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors around their optimal investment policies. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When stock prices reflect less information, the volatility of stock returns rises. The increase in volatility makes holding stocks unattractive, distorts the long-run level of capital accumulation, and causes costly (first-order) distortions in the long-run level of consumption.
    JEL: D83 E2 E3 G1
    Date: 2011–05
  11. By: di Iasio, Giovanni; Quagliariello, Mario
    Abstract: Following a decline in the fundamental risk of assets, the ability of banks to expand the balance sheet under a Value-at-Risk constraint in- creases (as in Adrian and Shin (2010)), boosting the bank’s incentives to provide costly monitoring effort that prevents asset deterioration. On the other hand, high asset demand and prices, eventually, raise the bank’s pay- off in the event of liquidation associated to asset deterioration, jeopardiz- ing incentives. This paper shows that a microprudential regulatory regime that disregards the equilibrium effect of macro variables (asset prices) on micro behavior (effort), performs poorly as low fundamental (exogenous) risk reduces bank’s effort and induces high (endogenous) deterioration risk. This analysis calls for a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account by the author- ity in designing incentive compatible capital requirements, providing a theoretical foundation to the countercyclical buffer of Basel III.
    Keywords: Macroprudential regulation; financial stability; capital requirement.
    JEL: D86 G18 E44
    Date: 2011–01–17
  12. By: Markus M. Mobius; Muriel Niederle; Paul Niehaus; Tanya S. Rosenblat
    Abstract: Evidence from social psychology suggests that agents process information about their own ability in a biased manner. This evidence has motivated exciting research in behavioral economics, but has also garnered critics who point out that it is potentially consistent with standard Bayesian updating. We implement a direct experimental test. We study a large sample of 656 undergraduate students, tracking the evolution of their beliefs about their own relative performance on an IQ test as they receive noisy feedback from a known data-generating process. Our design lets us repeatedly measure the complete relevant belief distribution incentive-compatibly. We find that subjects (1) place approximately full weight on their priors, but (2) are asymmetric, over-weighting positive feedback relative to negative, and (3) conservative, updating too little in response to both positive and negative signals. These biases are substantially less pronounced in a placebo experiment where ego is not at stake. We also find that (4) a substantial portion of subjects are averse to receiving information about their ability, and that (5) less confident subjects are causally more likely to be averse. We unify these phenomena by showing that they all arise naturally in a simple model of optimally biased Bayesian information processing.
    JEL: C91 C93 D83
    Date: 2011–05
  13. By: Augusto de la Torre; Alain Ize
    Abstract: Financial crises happen when: (i) nobody really understands what is going on (the collective cognition paradigm); (ii) some understand better and take advantage (the asymmetric information paradigm); (iii) everybody understands but crises are a natural part of the financial landscape (the market segmentation paradigm); or (iv) everybody understands yet fail to act because private and social interests do not coincide (the collective action paradigm). The four paradigms have different and often conflicting prudential policy implications. We propose and discuss three sets of reforms that would give due weight to the insights from the collective action and collective cognition paradigms by: (i) redrawing the regulatory perimeter to internalize systemic risk without promoting dynamic regulatory arbitrage; (ii) introducing a truly systemic liquidity regulation that moves away from a purely idiosyncratic focus on maturity mismatches; and (iii) building up the supervisory function while avoiding the pitfalls of expanded official oversight.
    Date: 2011–02–28
  14. By: Michele Battisti (University of Palermo); Giovanna Vallanti (LUISS "Guido Carli" University)
    Abstract: This paper focuses on the effects of decentralized wage schemes and temporary forms of employment on worker/firm performance. The effect of monetary incentives on worker effort and firm performance is a central topic in economics. According to the principal-agent paradigm, firms (the principal) have to link employees’ remuneration scheme to any verifiable indicator of performance in order to avoid opportunistic behaviours. The effectiveness of incentives on workers’ behaviour may vary significantly accordingly to the institutional/economic context in which the firms operate but in general the empirical evidence shows that financial incentives have the potential to exert strong effects on indicators of firm performance, such as productivity and worker absenteeism. Both from a theoretical and empirical point of view, the prediction on the effects of temporary forms of employment on effort and productivity is less neat. In light of these considerations, the aim of this paper is to provide further empirical evidence on whether and to what extent the performance related pay and the contract flexibility affect workers effort and in turn firm productivity for different type of workers (white collar vs. blue collar), working in workplaces characterized by different degree of uncertainty and risk and in firms operating in different economic and institutional settings using a sample of Italian firms. According to our results, wage flexibility appears to have a significant effect on effort and then on firm’s productivity and white collars are more responsive to monetary incentives than blue collars. Moreover, the presence of a large share of temporary contracts implies a lower dismissal probability for permanent workers and a deterioration in the working environment and then it reduces workers’ motivation and effort.
    Keywords: Productivity, Effort, Performance-related-pay, Temporary contracts.
    JEL: J22 J33 J38
    Date: 2011
  15. By: Armin Falk (University of Bonn and IZA); David Huffman (Swarthmore College and IZA); W. Bentley Macleod (Columbia University and IZA)
    Abstract: We provide evidence on how two important types of institutions – dismissal barriers, and bonus pay – affect contract enforcement behavior in a market with incomplete contracts and repeated interactions. Dismissal barriers are shown to have a strong negative impact on worker performance, and market efficiency, by interfering with firms' use of firing threat as an incentive device. Dismissal barriers also distort the dynamics of worker effort levels over time, cause firms to rely more on the spot market for labor, and create a distribution of relationship lengths in the market that is more extreme, with more very short and more very long relationships. The introduction of a bonus pay option dramatically changes the market outcome. Firms are observed to substitute bonus pay for threat of firing as an incentive device, almost entirely offsetting the negative incentive and efficiency effects of dismissal barriers. Nevertheless, contract enforcement behavior remains fundamentally changed, because the option to pay bonuses causes firms to rely less on long-term relationships. Our results show that market outcomes are the result of a complex interplay between contract enforcement policies and the institutions in which they are embedded.
    Keywords: incomplete contracts, bonus pay, efficiency wages, employment protection, firing costs, experiment
    JEL: J41 J3 C9 D01
    Date: 2011–05
  16. By: Loukas Balafoutas; Adrian Beck; Rudolf Kerschbamer; Matthias Sutter
    Abstract: Credence goods are characterized by informational asymmetries between sellers and consumers that invite fraudulent behavior by sellers. This paper presents the results of a natural field experiment on taxi rides in Athens, Greece, set up to measure different types of fraud and to examine the influence of passengers’ presumed information and income on the extent of fraud. Results reveal that taxi drivers cheat passengers in systematic ways: Passengers with inferior information about optimal routes are taken on longer detours while asymmetric information on the local tariff system leads to manipulated bills. Higher income seems to lead to more fraud.
    Keywords: Credence goods, expert services, natural field experiment, taxi rides, fraud, asymmetric information
    JEL: C93 D82
    Date: 2011–04
  17. By: Dittrich, Dennis A. V.; Kocher, Martin G.
    Abstract: We present an experimental test of a shirking model where monitoring intensity is endogenous and effort a continuous variable. Wage level, monitoring intensity and consequently the desired enforceable effort level are jointly determined by the maximization problem of the firm. As a result, monitoring and pay should be complements. In our experiment, between and within treatment variation is qualitatively in line with the normative predictions of the model under standard assumptions. Yet, we also find evidence for reciprocal behavior. Our data analysis shows, however, that it does not pay for the employer to solely rely on the reciprocity of employees.
    Keywords: incentive contracts; supervision; efficiency wages;experiment; incomplete contracts; reciprocity
    JEL: C91 J31 J41
    Date: 2011–01
  18. By: Jürgen-Peter Kretschmer (University of Marburg)
    Abstract: Many decision problems in various fields of application can be characterized as diagnostic problems trying to assess the true state (of the world) of given cases. The investigation of assessment criteria improves the initial information according to observed signal outcomes, which are related to the possible states. Such sequential investigation processes can be analyzed within the framework of statistical decision theory, in which prior probability distributions of classes of cases are updated, allowing for a sorting of particular cases into ever smaller subclasses. However, receiving such information causes investigation costs. Besides the question about the set of relevant criteria, this defines two additional problems of statistical decision problems: the optimal stopping of investigations and the optimal sequence of investigating a given set of criteria. Unfortunately, no solution exists with which the optimal sequence can generally be determined. Therefore, the paper characterizes the associated problems and analyzes existing heuristics trying to approximate an optimal solution.
    Keywords: Decision-Making, Uncertainty, Information, Bayesian Analysis, Statistical Decision Theory
    JEL: D80 D81 C11 C44
    Date: 2011
  19. By: Gérard Mondello (University of Nice Sophia Antipolis, CREDECO, GREDEG, UMR 6727, CNRS)
    Abstract: This paper addresses the conditions for setting up strict civil liability schemes. For that it compares the social efficiency of two main civil liability regimes usually enforced to protect the environment: the strict liability regime and the “capped strict liability scheme”. First, it shows that the regulator faces an effective dilemma when he has to enforce one of these schemes. This because the social cost of a severe harm (and the associated optimum care effort) is determined independently of any liability regime. This independency has economic consequences. First, victims and polluters pit one against another about the liability regime that the government should enforce. Hence, financially constrained polluters prefer the ceiling of responsibilities while victims wish to extend the amount of redress under a “standard” strict liability. Economic criteria for enforcing a regime rather than another one are lacking. Second, the paper shows that implementing civil strict liability rules may be done by setting up care standards as for instance in the nuclear or the maritime sectors and demanding to the injurers to comply with them. We show that this goal can be achieved by resorting to some friendly monitoring corresponding to frequent random controls with low fines rather than few controls that should involve heavy fines.
    Keywords: Environment, Strict Liability, Ex-Ante Regulation, Ex-Post Liability, Judgment-Proof, Environment Law, CERCLA, Environmental Liability
    JEL: K0 K32 Q01 Q58
    Date: 2011–02
  20. By: Casey Rothschild; Florian Scheuer
    Abstract: Recent policy proposals have suggested taxing top incomes at very high rates on the grounds that some or all of the highest wage earners are engaged in socially unproductive or counterproductive activities, such as externality imposing speculation in the financial sector. To address this, we provide a model in which agents can choose between working in a traditional sector, where private and social products coincide, and a crowdable rent-seeking sector, where some or all of earned income reflects the capture of pre-existing output rather than increased production. We characterize Pareto optimal linear and non-linear income tax systems under the assumption that the social planner cannot or does not observe whether any given individual is a traditional worker or a rent-seeker. We find that optimal marginal taxes on the highest wage earners can remain remarkably modest even if all high earners are socially unproductive rent-seekers and the government has a strong intrinsic desire for progressive redistribution. Intuitively, taxing their effort at a lower rate stimulates their rent-seeking efforts, thereby keeping private returns for other potential rent-seekers low and discouraging further entry.
    JEL: D3 D5 D8 E2 E6 H2
    Date: 2011–05
  21. By: Lunander, Anders (Swedish Business School); Lundberg, Sofia (Department of Economics, Umeå University)
    Abstract: Combinatorial procurement auctions enable suppliers to pass their potential cost synergies on to the procuring entity and may therefore lead to lower costs and enhance efficiency. However, bidders might find it profitable to inflate their stand-alone bids in order to favour their package bids. Using data from standard and combinatorial procurement auctions, we find that bids on individual contracts in simultaneous standard auctions without the option to submit package bids are significantly lower than the corresponding stand-alone bids in combinatorial auctions. Further, no significant difference in procurer’s cost as explained by auction format is found.
    Keywords: Combinatorial procurement auctions; Contract bidding
    JEL: D44 H57
    Date: 2011–04–20

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