nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2011‒06‒25
twelve papers chosen by
Simona Fabrizi
Massey University, Albany

  1. The roles of incentives and voluntary cooperation for contractual compliance By Simon Gaechter; Esther Kessler; Manfred Koenigstein
  2. A Theory of Soft Capture By Axel Gautier; Per J. Agrell
  3. Growth, Selection and Appropriate Contracts By Alessandra Bonfiglioliy; Gino Gancia
  4. Optimal Delegation with a Finite Number of States By Vincent Anesi; Daniel J. Seidmann
  5. Managerial incentives under competitive pressure: Experimental investigation By Ahmed Ennasri; Marc Willinger
  6. Almost common value auctions: more equilibria. By Gisèle Umbhauer
  7. International Migration, Imperfect Information and Brain Drain By Vianney Dequiedt; Yves Zenou
  8. The Division of Labor and The Theory of the Firm By Michael T. Rauh
  9. Incentives vs. Selection in Promotion Tournaments: Can a Designer Kill Two Birds with One Stone? By Höchtl, Wolfgang; Kerschbamer, Rudolf; Stracke, Rudi; Sunde, Uwe
  10. The Effect of Land Scarcity on Farm Structure: Empirical Evidence from Mali By Catherine Guirkinger; Jean-Philippe Platteau
  11. CDS as Insurance: Leaky Lifeboats in Stormy Seas By Stephens, Eric; Thompson, James
  12. An Investigation of the Strategic Implications of Environmental Monitoring By Alberto Casagrande; Marco Spallone

  1. By: Simon Gaechter (University of Nottingham); Esther Kessler (University College London); Manfred Koenigstein (Universitaet Erfurt)
    Abstract: Efficiency under contractual incompleteness often requires voluntary cooperation in situations where self-regarding incentives for contractual compliance are present as well. Here we provide a comprehensive experimental analysis based on the gift-exchange game of how explicit and implicit incentives affect cooperation. We first show that there is substantial cooperation under non-incentive compatible contracts. Incentive-compatible contracts induce best-reply effort and crowd out any voluntary cooperation. Further experiments show that this result is robust to two important variables: experiencing Trust contracts without any incentives and implicit incentives coming from repeated interaction. Implicit incentives have a strong positive effect on effort only under non-incentive compatible contracts.
    Keywords: principal-agent games; gift-exchange experiments; incomplete contracts, explicit incentives; implicit incentives; repeated games; separability; experiments
    JEL: C70 C90
    Date: 2011–06
  2. By: Axel Gautier; Per J. Agrell
    Abstract: Capture of regulatory agencies by firms or other stakeholders has given rise to a rich literature, much of which is dominated by models in which the motivation for the welfare-reducing behavior is found in side-contracting (bribes, corruption), threats (blackmail, political support) or corresponding mechanisms for repeated games (reputation, career concerns, signaling for promotion). Notwithstanding, the empirical support for monetary corruption and 'revolving doors' is scarce and inconclusive. We propose an alternative and more intuitive model for regulatory capture that is based on information transmission and asymmetric information. In a three-tier model, a regulator is charged by a political principal to provide a signal for the type of a regulated firm. Only the firm can observe his type and the production of a correlated signal with a given accuracy is costly for the regulator. The firm can costlessly provide an alternative signal of lower accuracy that is presented to the regulator. In a self-enforcing equilibrium, the regulator transmits the firm-produced signal, internalizes its own savings in information cost and the firm enjoys higher information rents. The main feature of soft capture is that it is not based on a reciprocity of favors but on a congruence of interests between the firm and the regulator.
    Date: 2011
  3. By: Alessandra Bonfiglioliy; Gino Gancia
    Abstract: We study a dynamic model where growth requires both long-term investment and the selection of talented managers. When ability is not ex-ante observable and contracts are incomplete, managerial selection imposes a cost, as managers facing the risk of being replaced tend to choose a sub-optimally low level of long-term investment. This generates a trade-off between selection and investment that has implications for the choice of contractual relationships. Our analysis shows that rigid long-term contracts sacrificing managerial selection may be optimal at early stages of economic development and when access to information is limited. As the economy grows, however, knowledge accumulation increases the return to talent and makes it optimal to adopt flexible contractual relationships, where managerial selection is implemented even at the cost of lower investment. Better institutions, in the form of a richer contracting environment and less severe informational frictions, speed up the transition to short-term relationships.
    Keywords: information, selection, appropriate contracts, development, growth, appropriate institutions.
    JEL: D8 O40
    Date: 2011–06–17
  4. By: Vincent Anesi (University of Nottingham); Daniel J. Seidmann (University of Nottingham)
    Abstract: This paper studies delegation without monetary transfers when the number of possible states is small, and therefore finite. To do so, we fully characterize the class of optimal delegation sets in the finite-state version of Holmstrom’s (1984) seminal model and analyze their properties. Our finite state assumption entails the following results: (i) the agent never takes her ideal decision, and takes a decision strictly between her and the principal’s ideal (thus compromising with the latter) in low enough states; (ii) the agent takes the same decision in high enough states, and is indifferent between the decision she takes and the next highest decision in every other state; (iii) the agent may be induced to take decisions outside the support of the principal’s ideal decisions; (iv) marginal increases in the agent’s bias do not (generically) cause optimal delegation sets to shrink, and may increase the variance of the decision taken by the agent. We also show that the principal and the agent may both be better off if the latter cannot distinguish between some states.
    Keywords: Optimal delegation, finite states, Ally Principle, expertise
    Date: 2011–04
  5. By: Ahmed Ennasri; Marc Willinger
    Abstract: We investigate the effects of competition on managerial incentives and effort in a laboratory experiment. Each owner offers compensation to his manager in two different contexts: monopoly and Cournot duopoly. After accepting the compensation, the manager chooses an effort level to increase the probability of reduced costs of his firm. Theory predicts that the entry of a rival firm in a monopolistic industry affects negatively both the incentive compensation and the effort level. Our experimental findings confirm that the entry of a rival firm reduces the incentive compensation but not the manager’s effort level. However, despite the reduction of the incentive compensation, the manager continues to accept the contract offers and exert the same level of effort.
    Keywords: Managerial Incentives, Effort, Competition, Moral hazard, Experiments
    Date: 2011–06
  6. By: Gisèle Umbhauer
    Abstract: In almost common value auctions, even a very small private payoff advantage is usually supposed to have an explosive effect on the outcomes in a second- price sealed-bid auction. According to Bikhchandani (1988) and Klemperer (1997) the large set of equilibria obtained for common value auction games drastically shrinks, so that the advantaged player always wins the auction, at a price that sharply decreases the seller’s payoff. Yet this result has not been observed experimentally. In this paper, we show that Bikhchandani’s equilibria are not the only equilibria of the game. By allowing bids to not continuously depend on private information, we establish a new family of perfect equilibria with nice properties: the advantaged bidder does no longer win the auction regardless of her private information, she may pay a much higher price than in Bikhchandani’s equilibria, there is no ex post regret for both the winner and the looser, and the equilibria give partial support to some naïve behaviour observed experimentally.
    Keywords: common value auctions, second-price sealed-bid auctions, Nash equilibrium, perfect equilibrium.
    JEL: C72 D44
    Date: 2011
  7. By: Vianney Dequiedt (Université d’Auvergne); Yves Zenou (Stockholm University, IFN, and CEPR)
    Abstract: We consider a model of international migration where skills of workers are imperfectly observed by firms in the host country and where information asymmetries are more severe for immigrants than for natives. There are two stages. In the first one, workers in the South decide whether to move and pay the migration costs. These costs are assumed to be sunk. In the second stage, firms offer wages to the immigrant and native workers who are in the country. Because of imperfect information, firms statistically discriminate high-skilled migrants by paying them at their expected productivity. The decision of whether to migrate or not depends on the proportion of high-skilled workers among the migrants. The migration game exhibits strategic complementarities, which, because of standard coordination problems, lead to multiple equilibria. We characterize them and examine how international migration affects the income of individuals in sending and receiving countries, and of migrants themselves. We also analyze under which conditions there is positive or negative self-selection of migrants.
    Keywords: asymmetric information, screening, self-selection of migrants, skill-biased migration, wage differentials
    JEL: D82 J61 F22 O12
    Date: 2011–06
  8. By: Michael T. Rauh (Department of Business Economics and Public Policy, Indiana University Kelley School of Business)
    Abstract: We extend the classical teams framework to the case where team size is endogenous and workers can specialize within a division of labor. We consider two institutions: equal-division partnerships and the firm with a budget-breaker. In contrast with the previous literature, we show that effort and team size in partnerships can be greater or less than first best. Our results for the firm are driven by two main insights. First, the budgetbreaker can increase effort with an increase in incentives and/or specialization. Second, incentives and employment are strategic substitutes. We show that the budget-breaker offers incentives that are weaker than first best or equal-division partnership incentives, so that shirking is more prevalent in the firm. Since incentives and team size are substitutes, the budget-breaker increases employment above the first best and partnership levels, so the firm is inefficiently large. The role of the budget-breaker is therefore to reduce agents' exposure to risk and to promote and coordinate specialization and the division of labor. The comparative statics of the firm are consistent with several institutional stylized facts (e.g., the size-wage effect) and recent organizational trends.
    Keywords: budget-breaker, division of labor, endogenous team size, incentives, moral hazard, partnerships, size-wage eect, specialization, teams, theory of the rm
    JEL: D02 D21 D86 L25 M5
    Date: 2011–04
  9. By: Höchtl, Wolfgang (University of Innsbruck); Kerschbamer, Rudolf (University of Innsbruck); Stracke, Rudi (University of St. Gallen); Sunde, Uwe (University of St. Gallen)
    Abstract: This paper studies the performance of promotion tournaments with heterogeneous participants in two dimensions: incentive provision and selection. Our theoretical analysis reveals a trade-off for the tournament designer between the two goals: While total effort is maximized if less heterogeneous participants compete against each other early in the tournament, letting more heterogeneous participants compete early increases the accuracy in selection. Experimental evidence supports our theoretical findings, indicating that the optimal design of promotion tournaments crucially depends on the objectives of the tournament designer. These findings have important implications for the optimal design of promotion tournaments in organizations.
    Keywords: promotion tournaments, heterogeneity, incentive provision, selection
    JEL: M52 J33
    Date: 2011–05
  10. By: Catherine Guirkinger (Center for Research in the Economics of Development, University of Namur); Jean-Philippe Platteau (Center for Research in the Economics of Development, University of Namur)
    Abstract: We analyze the individualization of farm units in Mali in the sense of a transformation of purely collective farms into mixed units in which private plots coexist with collective fields. While a moral-hazard-in-team problem plagues production on the latter, a dilemma arises insofar as the household head extracts his income form it. The head thus faces a trade-off between efficiency and capture. We show, within the framework of a patriarchal farm household model, that the choice is tilted toward private plot as land becomes more scarce. On the basis of first hand data collected in Southern Mali, we test and confirm the above prediction. Moreover, the relationship between land scarcity and the presence of individual plots holds only when there are at least one married couple (besides the head) within the household. The explanation we put forward is that the presence or suspicion of labour-shirking on the collective field arise only when there are interferences by in-laws and differences in the size of conjugal units.
    Date: 2011–05
  11. By: Stephens, Eric (University of Alberta, Department of Economics); Thompson, James (University of Waterloo, School of Accounting and Business)
    Abstract: In this paper we update the traditional insurance economics framework to incorporate key features of the credit default swap (CDS) market. First, we allow for insurer insolvency, with asymmetric information as to its probability. We find that stable insurers become less stable because they are forced to compete on price. When insurer type is known, increased competition among insurers can create instability for the same reason. Second, we allow the insured party to have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for speculation. We show that speculators will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that disallows speculative trading can, perversely, cause market counterparty risk to increase. Third, we relax the standard assumption of contract exclusivity, which does not apply to the CDS market, by allowing the insured to purchase contracts from many insurers. In contrast to the traditional insurance model, we show that separation of risk type among insured parties can be achieved through insurer choice. We use our model to shed light on the debate over Central Counterparties (CCP). We show that requiring CDS contracts to be negotiated through CCPs can push stable insurers out of the market, mitigating the benefi t of risk pooling.
    Keywords: credit default swaps; insurance; counterparty risk; banking; regulation
    JEL: D82 G18 G21 G22
    Date: 2011–06–16
  12. By: Alberto Casagrande (The Core Consulting, Inc., Rome, Italy); Marco Spallone (G. D'Annunzio University of Pescara and LUISS Guido Carli University)
    Abstract: A ÞrmÕs decision of obeying environmental regulatory standards depends crucially on its chances of being detected and on the costs it must bear in case of detection. We investigate the relationship between the amount of resources devoted to environmental monitoring and the extent of non-compliancy, using a game theoretical model to capture the strategic implications of the monitoring process. In our model a population of Þrms, each of whom decides whether or not to be compliant, and a monitoring agency, that can detect non-compliance only by monitoring signals, strategically interact (more precisely, each Þrm interacts both with the monitoring agency and all other Þrms). In particular, each Þrm produces a signal, the distribution of which is (not perfectly) correlated with its behavior, while the agency, that is resource constrained, chooses some (optimal) fraction of the signals to monitor; hence, the probability of being monitored for each Þrm depends crucially on the behavior of both the monitoring agency and all other Þrms. Simply put, if a large fraction of Þrms chooses not to obey regulatory standards, the probability of being monitored for non-compliant Þrms is small. The main consequence of the strategic interaction among Þrms is that a more aggressive monitoring policy may end up relaxing the resource constraint of the monitoring agency as long as enough Þrms, perceiving a higher chance of being detected, become compliant. In fact, while in a framework with no strategic interaction a more aggressive monitoring policy simply induces a larger fraction of Þrms to be compliant (we call this e!ect, recognized by Becker and Stigler in their seminal contributions, Òimpact effectÓ), in our model a more aggressive monitoring policy also implies a higher probability of being monitored for the remaining non-compliant Þrms, and, in turn, implies a further switch to compliancy. We show that this further switch, that we call ÒmagniÞcation effectÓ, can be very relevant; hence, when monitoring policies are to be designed, our advice is to take strategic interaction among Þrms in the right consideration.
    Keywords: Environment, Monitoring, Strategic Interactions.
    JEL: Q50 Q58
    Date: 2011

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