nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2012‒02‒01
seventeen papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Collateral Crises By Gary B. Gorton; Guillermo Ordonez
  2. Mediation and Peace By Horner, Johannes; Morelli, Massimo; Squintani, Francesco
  3. Risk-sharing or risk-taking? Counterparty risk, incentives and margins By Bruno Biais; Florian Heider; Marie Hoerova
  4. A Theory of Multidimensional Information Disclosure By Wataru Tamura;
  5. Output taxation by a revenue-raising government under signaling By Manel Antelo
  6. Optimal disclosure policy and undue diligence By David Andolfatto; Aleksander Berentsen; Christopher J. Waller
  7. The Overpricing Problem: Moral Hazard and Franchises By Eckert, Heather; van Egteren, Henry; Hannweber, Troy
  8. On the Efficiency of Partial Information in Elections By Jon X. Eguia; Antonio Nicolò
  9. Signalling rivalry and quality uncertainty in a duopoly By Bester, Helmut; Demuth, Juri
  10. Policy Implications of Using Audits to Detect Bank Insolvencies By Jaime Hurtubia; Claudio Sardoni
  11. Efficient Auctions and Interdependent Types By Dirk Bergemann; Stephen Morris; Satoru Takahashi
  12. Bounded Rationality in Principal‐Agent Relationships By Mathias Erlei; Heike Schenk-Mathes
  13. Loan Defaults in Africa By Svetlana Andrianova; Badi H Baltagi; Panicos O Demetriades
  14. Beliefs and rationalizability in games with complementarities By Mathevet, Laurent
  15. Some unpleasant general equilibrium implications of executive incentive compensation contracts By John B. Donaldson; Natalia Gershun; Marc P. Giannoni
  16. Respect and relational contracts By Tor Eriksson; Marie-Claire Villeval
  17. Reputation, Competition, and Entry in Procurement By Spagnolo, Giancarlo

  1. By: Gary B. Gorton; Guillermo Ordonez
    Abstract: Short-term collateralized debt, such as demand deposits and money market instruments - private money, is efficient if agents are willing to lend without producing costly information about the collateral backing the debt. When the economy relies on such informationally-insensitive debt, firms with low quality collateral can borrow, generating a credit boom and an increase in output and consumption. Financial fragility builds up over time as information about counterparties decays. A crisis occurs when a small shock then causes a large change in the information environment. Agents suddenly have incentives to produce information, asymmetric information becomes a threat and there is a decline in output and consumption. A social planner would produce more information than private agents, but would not always want to eliminate fragility.
    JEL: E2 E20 E32 E44 G01 G2 G20
    Date: 2012–01
  2. By: Horner, Johannes (Yale University); Morelli, Massimo (European University Institute; Columbia University,); Squintani, Francesco (University of Warwick)
    Abstract: This paper applies mechanism design to con ict resolution. We determine when and how unmediated communication and mediation reduce the ex ante probability of con ict in a game with asymmetric information. Mediation improves upon unmediated communication when the intensity of con ict is high, or when asymmetric information is signi cant. The mediator improves upon unmediated communication by not precisely reporting information to con icting parties, and precisely, by not revealing to a player with probability one that the opponent is weak. Arbitrators who can enforce settlements are no more e ective than mediators who only make non-binding recommendations.
    Date: 2011
  3. By: Bruno Biais (Toulouse School of Economics (CNRS-CRM, IDEI), 21 Allée de Brienne, 31000 Toulouse, France.); Florian Heider (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Marie Hoerova (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: We analyze optimal hedging contracts and show that although hedging aims at sharing risk, it can lead to more risk-taking. News implying that a hedge is likely to be loss-making undermines the risk-prevention incentives of the protection seller. This incentive problem limits the capacity to share risks and generates endogenous counterparty risk. Optimal hedging can therefore lead to contagion from news about insured risks to the balance sheet of insurers. Such endogenous risk is more likely to materialize ex post when the ex ante probability of counterparty default is low. Variation margins emerge as an optimal mechanism to enhance risk-sharing capacity. Paradoxically, they can also induce more risk-taking. Initial margins address the market failure caused by unregulated trading of hedging contracts among protection sellers. JEL Classification: G21, G22, D82.
    Keywords: Insurance, moral hazard, counterparty risk, margin requirements, derivatives.
    Date: 2012–01
  4. By: Wataru Tamura;
    Abstract: We study disclosure of information about the multidimensional state of the world when uninformed receivers' actions affect the sender's utility. Given a disclosure rule, the receivers form an expectation about the state following each message. Under the assumption that the senderfs expected utility is written as the expected value of a quadratic function of those conditional expectations, we identify conditions under which full and no disclosure is optimal for the sender and show that a linear transformation of the state is optimal if it is normally distributed. We apply our theory to advertising, political campaigning, and monetary policy.
    Date: 2012–01
  5. By: Manel Antelo (Universidad de Santiago de Compostela)
    Abstract: In this paper the behavior of a tax-collecting government (a tax office) when imposing a quantity-tax to firms is analyzed along a two-period signaling model. Each taxpayer privately knows its technological attributes, while third parties—the tax office among them—have only a prior belief about this fact, so firms can be tempted to behave opportunistically. In monopoly, signaling is always costly in terms of output deviation and the tax office reacts by setting, a smaller tax in (asymmetric information) period 1 than it would under symmetric information. In oligopoly, signaling can be either costly or costless. In the former case, the tax imposed by the tax office to each firm is below that imposed under symmetric information, while it is equal in the latter case. Besides, fiscal revenue under signaling is unambiguously lower than under symmetric information, even when tax size is the same in both contexts
    Keywords: Output-tax, tax office, asymmetric information, signaling
    JEL: H21 D82
    Date: 2011
  6. By: David Andolfatto; Aleksander Berentsen; Christopher J. Waller
    Abstract: While both public and private financial agencies supply asset markets with large amounts of information, they do not generally disclose all asset-related information to the general public. This observation leads us to ask what principles might govern the optimal disclosure policy for an asset manager or financial regulator. To investigate this question, we study the properties of a dynamic economy endowed with a risky asset, and with individuals that lack commitment. Information relating to future asset returns is available to society at zero cost. Legislation dictates whether this information is to be made public or not. Given the properties of our environment, nondisclosure is generally desirable. This result is overturned, however, when individuals are able to access hidden information—what we call undue diligence—at sufficiently low cost. Information disclosure is desirable, in other words, only to the extent that individuals can easily discover it for themselves.
    Date: 2012
  7. By: Eckert, Heather (University of Alberta, Department of Economics); van Egteren, Henry (University of Alberta, Department of Economics); Hannweber, Troy (University of Alberta, Department of Economics)
    Abstract: We hypothesize that moral hazard is an important factor in explaining the under performance of firms, identified by Ritter (1991), following initial public offerings (IPOs). We test this hypothesis by comparing post-IPO returns of franchised and non-franchised firms. Franchised IPOs, whose franchise agreements mitigate the moral hazard problems that arise from the dilution of ownership following an IPO, outperform their non-franchised, matched counterpart IPOs over five years in the aftermarket.
    Keywords: IPO; moral hazard; overpricing; franchises
    JEL: G14
    Date: 2012–01–01
  8. By: Jon X. Eguia; Antonio Nicolò
    Abstract: We study the relation between the electorate's information about candidates' policy platforms during an election, and the subsequent provision of inefficient local public goods (pork) by the winning candidate. More information does not lead to better outcomes. We show that the efficient outcome in which no candidate proposes to provide any inefficient good is sustained in equilibrium only if voters are not well informed. If the electorate is well informed, electoral competition leads candidates to provide inefficient pork in all equilibria. We show that this result is robust even if candidates care about efficiency.
    Keywords: Elections, information, inefficiency, pork, campaigns
    JEL: H40 D61 D72
    Date: 2011
  9. By: Bester, Helmut; Demuth, Juri
    Abstract: This paper considers a market in which only the incumbent's quality is publicly known. The entrant's quality is observed by the incumbent and some fraction of informed consumers. This leads to price signalling rivalry between the duopolists, because the incumbent gains and the entrant loses when observed prices make the uninformed consumers more pessimistic about the entrant's quality. When the uninformed consumers' beliefs satisfy the intuitive criterion and the unprejudiced belief refinement, only a two-sided separating equilibrium can exist and prices are identical to the full information outcome. --
    Keywords: quality uncertainty,signalling,oligopoly
    JEL: D43 D82 L15
    Date: 2011
  10. By: Jaime Hurtubia; Claudio Sardoni
    Abstract: We present a model where a regulator has to decide how to tackle the potential insolvency of a bank in a context of asymmetric information. We show that, when it can audit the bank, the regulator is unlikely to choose a policy of bailout to induce the bank to reveal its insolvency. We show that, in some circumstances, the regulator can induce the bank to reveal its insolvency by threatening to randomize its decision to nationalize the bank.
    Date: 2011–12
  11. By: Dirk Bergemann (Cowles Foundation, Yale University); Stephen Morris (Dept. of Economics, Princeton University); Satoru Takahashi (Dept. of Economics, Princeton University)
    Abstract: We consider the efficient allocation of a single good with interdependent values in a quasi-linear environment. We present an approach to modelling interdependent preferences distinguishing between "payoff types" and "belief types" and report a characterization of when the efficient allocation can be partially Bayesian implemented on a finite type space. The characterization can be used to unify a number of sufficient conditions for efficient partial implementation in this classical auction setting. We report how a canonical language for discussing interdependent types -- developed in a more general setting by Bergemann, Morris and Takahashi (2011) -- applies in this setting and note by example that this canonical language will not allow us to distinguish some types in the payoff type -- belief type language.
    Keywords: Mechanism Design, Robust mechanism design, Efficient auctions, Interdepedent types, Partial implementation, Full implementation
    JEL: C79 D82
    Date: 2012–01
  12. By: Mathias Erlei; Heike Schenk-Mathes (Abteilung für Volkswirtschaftslehre, Technische Universität Clausthal (Department of Economics, Technical University Clausthal))
    Abstract: We conducted six treatments of a standard moral hazard experiment with hidden action. All treatments had identical Nash equilibria. However, the behavior in all treatments and periods was inconsistent with established agency theory (Nash equilibrium). In the early periods of the experiment, behavior differed significantly between treatments. This difference largely vanished in the final periods. We used logit equilibrium (LE) as a device to grasp boundedly rational behavior and found the following: (1) LE predictions are much closer to subjects’ behavior in the laboratory; (2) LE probabilities of choosing between strategies and experimental behavior show remarkably similar patterns; and (3) profit‐maximizing contract offers according to the LE are close to those derived from regressions.
    Keywords: experiment, logit equilibrium, moral hazard, hidden action
    JEL: C72 C92 J31 L14
    Date: 2012
  13. By: Svetlana Andrianova; Badi H Baltagi; Panicos O Demetriades
    Abstract: African financial deepening is beset by a high rate of loan defaults, which encourages banks to hold liquid assets instead of lending. We put forward a novel theoretical model that captures the salient features of African credit markets which shows that equilibrium with high loan defaults and low lending can arise when contract enforcement institutions are weak, investment opportunities are relatively scarce and information imperfections abound. We provide evidence using a panel of 110 banks from 29 African countries which corroborates our theoretical predictions.
    Keywords: Financial development; Africa
    JEL: G21 O16
    Date: 2011–08
  14. By: Mathevet, Laurent
    Abstract: We propose two characteristics of players' beliefs and study their role in shaping the set of rationalizable strategy profiles in games with incomplete information. The first characteristic, type-sensitivity, is related to how informative a player thinks his type is. The second characteristic, optimism, is related to how "favorable" a player expects the outcome of the game to be. The paper has two main results: the first result provides an upper bound on the size of the set of rationalizable strategy profiles, the second gives a lower bound on the change of location of this set. These bounds have explicit and relatively simple expressions that feature type-sensitivity, optimism, and properties of the payoffs. Our results generalize and clarify the well-known uniqueness result of global games (Carlsson and van Damme (1993)). They imply new uniqueness results and allow to study rationalizability in new environments. We provide applications to supermodular mechanism design (Mathevet (2010)) and non-Bayesian updating (Epstein (2006)).
    Keywords: Complementarities; rationalizability; beliefs; type-sensitivity; optimism; global games; equilibrium uniqueness
    JEL: D82 D83 C72
    Date: 2012–01–05
  15. By: John B. Donaldson; Natalia Gershun; Marc P. Giannoni
    Abstract: We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. A generic family of compensation contracts similar to those employed in practice is studied. When compensation is convex in the firm’s own dividend (or share price), a given increase in the firm’s output generated by an additional unit of physical investment results in a more than proportional increase in the manager’s income. Incentive contracts of sufficient yet modest convexity are shown to result in an indeterminate general equilibrium, one in which business cycles are driven by self-fulfilling fluctuations in the manager’s expectations that are unrelated to the economy’s fundamentals. Arbitrarily large fluctuations in macroeconomic variables may result. We also provide a theoretical justification for the proposed family of contracts by demonstrating that they yield first-best outcomes for specific parameter choices.
    Date: 2011
  16. By: Tor Eriksson (Department of economics - University of Aarhus); Marie-Claire Villeval (GATE Lyon Saint-Etienne - Groupe d'analyse et de théorie économique - CNRS : UMR5824 - Université Lumière - Lyon II - École Normale Supérieure de Lyon)
    Abstract: Assuming that people care not only about what others do but also on what others think, we study respect in a labor market context where the length of the employment relationship is endogenous. In our three-stage gift-exchange experiment, the employer can express respect by giving the employee costly symbolic rewards after observing his level of effort. We study whether symbolic rewards are used by the employers mainly to praise employees or as a coordination device to build relational contracts by manipulating the balance between labor demand and supply in the market. We find that a high proportion of long-term relationships have been initiated by the assignment of symbolic rewards. However, the assignment of symbolic rewards decreases when it becomes clear that the relationship is durable, suggesting that employers mainly use symbolic rewards as a coordination device to initiate relational contracts. Compared to the balanced market condition, assigning symbolic rewards in initial relationships is less likely when there is excess demand in the market and more likely when there is excess supply, i.e. when the relationship is more valuable. Receiving symbolic rewards increases the employees' likelihood of accepting to continue the relationship with the same employer. It also motivates them to increase their effort further but only when the market is balanced. Overall, the ability to assign symbolic rewards does not give rise to higher profits because it is associated with lower rents offered to the employees on average, leading to lower effort levels.
    Keywords: Respect; Symbolic rewards; Coordination; Signaling; Labor market; Experiment
    Date: 2012
  17. By: Spagnolo, Giancarlo (Stockholm Institute of Transition Economics)
    Abstract: Based on my recent work with several co-authors this paper explores the relationship between discretion, reputation, competition and entry in procurement markets. I focus especially on public procurement, which is highly regulated for accountability and trade reasons. In Europe regulation constrains the use of past performance information to select contractors while in the US its use is encouraged. I present some novel evidence on the benefits of allowing buyers to use reputational indicators based on past performance and discuss the complementary roles of discretion and restricted competition in reinforcing relational/reputational forces, both in theory and in a new empirical study on the effects restricted rather than open auctions. I conclude reporting preliminary results form a laboratory experiment showing that reputational mechanisms can be designed to stimulate rather than hindering new entry.
    Keywords: Accountability; Discretion; Entry; Incomplete contracts; Limited enforcement; Past performance; Procurement; Quality; Relational contracts; Reputation; Restricted auctions.
    JEL: H57 L14 L15 L24
    Date: 2012–01–07

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