nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2012‒03‒28
nineteen papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Team beats collusion By Barlo, Mehmet; Ayca, Ozdogan
  2. Caught between Scylla and Charybdis? Regulating bank leverage when there is rent-seeking and risk-shifting By Acharya, Viral V; Mehran, Hamid; Thakor, Anjan
  3. Smart Buyers By Burkart, Mike; Lee, Samuel
  4. Signalling, Incumbency Advantage, and Optimal Reelection Thresholds By Caselli, Francesco; Cunningham, Tom; Morelli, Massimo; Moreno de Barreda, Inés
  5. Innovation, Spillovers and Venture Capital Contracts By Dessí, Roberta
  6. A Theory of Income Smoothing When Insiders Know More Than Outsiders By Acharya, Viral V; Lambrecht, Bart
  7. Competition for traders and risk By Bijlsma, Michiel; Boone, Jan; Zwart, Gijsbert
  8. Bank Bonuses and Bail-outs By Hakenes, Hendrik; Schnabel, Isabel
  9. A Numerical Approach to the Contract Theory: the Case of Adverse Selection By Hideo Hashimoto; Kojun Hamada; Nobuhiro Hosoe
  10. Homo Moralis-Preference evolution under incomplete information and assortative matching By Alger, Ingela; Weibull, Jörgen
  11. Aggregate Investment Externalities and Macroprudential Regulation By Gersbach, Hans; Rochet, Jean-Charles
  12. The Firm as the Locus of Social Comparisons: Internal Labor Markets versus Up-or-out By Auriol, Emmanuelle; Friebel, Guido; Lammers, Frauke
  13. How acid are lemons? Adverse selection and signalling for skilled labour market entrants By Wagner, Robert; Zwick, Thomas
  14. On the optimal supply of liquidity with borrowing constraints By Lippi, Francesco; Trachter, Nicholas
  15. Flexibility and Collusion with Imperfect Monitoring By Bigoni, Maria; Potters, Jan; Spagnolo, Giancarlo
  16. Does Cost Uncertainty in the Bertrand Model Soften Competition? By Lagerlöf, Johan N. M.
  17. The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle By Acharya, Viral V; Naqvi, Hassan
  18. The advertising mix for a search good By Anderson, Simon P.; Renault, Régis
  19. Getting The Right Spin: A Theory Of Optimal Viral Marketing By Pier-André Bouchard St-Amant

  1. By: Barlo, Mehmet; Ayca, Ozdogan
    Abstract: This paper analyzes optimal contracts in a linear hidden-action model with normally distributed returns possessing two moments that are governed jointly by two agents, who can observe each others' effort levels and draft enforceable side-contracts on chosen effort levels and realized returns. After showing that standard constraints, resulting in incentive-contracts, may fail to ensure implementability, we examine (centralized) collusion-proof contracts and (decentralized) team-contracts. We prove that optimal team-contracts provide the highest implementable returns to the principal. In other words, the principal may restrict attention to outsourcing/decentralization without any loss of generality. Moreover, situations in which incentive-contracts are collusion-proof, thus implementable, are fully characterized.
    Keywords: Principal-agent problems; moral hazard; linear contracts; side--contracting; collusion; team; outsourcing; decentralization
    JEL: D82 M12 J30
    Date: 2012–03–19
  2. By: Acharya, Viral V; Mehran, Hamid; Thakor, Anjan
    Abstract: We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.
    Keywords: asset substitution; bailout; market discipline; systemic risk
    JEL: G21 G28 G32 G35 G38
    Date: 2012–02
  3. By: Burkart, Mike; Lee, Samuel
    Abstract: In many bilateral transactions, the seller fears being underpaid because its outside option is better known to the buyer. We rationalize a variety of observed contracts as solutions to such smart buyer problems. The key to these solutions is to grant the seller upside participation. In contrast, the lemons problem calls for offering the buyer downside protection. Yet in either case, the seller (buyer) receives a convex (concave) claim. Thus, contracts commonly associated with the lemons problem can equally well be manifestations of the smart buyer problem. Nevertheless, the information asymmetries have opposite cross-sectional implications. To avoid underestimating the empirical relevance of adverse selection problems, it is therefore critical to properly identify the underlying information asymmetries in the data.
    Keywords: Asymmetric Information; Bilateral trade; Cash-Equity Offers; Commissions; Contingent Value Rights; Debt-Equity Swaps; Lemons Problem; Royalties
    JEL: D82 D84
    Date: 2012–01
  4. By: Caselli, Francesco; Cunningham, Tom; Morelli, Massimo; Moreno de Barreda, Inés
    Abstract: Much literature on political behavior treats politicians as motivated by reelection, choosing actions to signal their types to voters. We identify two novel implications of models in which signalling incentives are important. First, because incumbents only care about clearing a reelection hurdle, signals will tend to cluster just above the threshold needed for reelection. This generates a skew distribution of signals leading to an incumbency advantage in the probability of election. Second, voters can exploit the signalling behavior of politicians by precommitting to a higher threshold for signals received. Raising the threshold discourages signalling effort by low quality politicians but encourages effort by high quality politicians, thus increasing the separation of signals and improving the selection function of an election. This precommitment has a simple institutional interpretation as a supermajority rule, requiring that incumbents exceed some fraction of votes greater than 50% to be reelected. A simple calibration suggests the average quality of US Congress members would be maximised by requiring a 57% vote share for reelection.
    Keywords: Incumbency Advantage; Signalling; Sipermajority
    JEL: D72 D78 D82
    Date: 2012–02
  5. By: Dessí, Roberta
    Abstract: Innovative start-ups and venture capitalists are highly clustered, benefiting from localized spillovers: Silicon Valley is perhaps the best example. There is also substantial geographical variation in venture capital contracts: California contracts are more 'incomplete'. This paper explores the economic link between these observations. In the presence of significant spillovers, it becomes optimal for an innovative start-up and its financier to adopt contracts with fewer contingencies: these contracts maximize their ability to extract (part of) the surplus they generate through positive spillovers. This relaxes ex-ante financing constraints and makes it possible to induce higher innovative effort.
    Keywords: incomplete contracts; innovation; spillovers; venture capital
    JEL: D82 D86 G24 L22
    Date: 2012–01
  6. By: Acharya, Viral V; Lambrecht, Bart
    Abstract: We consider a setting in which insiders have information about income that outside shareholders do not, but property rights ensure that outside shareholders can enforce a fair payout. To avoid intervention, insiders report income consistent with outsiders' expectations based on publicly available information rather than true income, resulting in an observed income and payout process that adjust partially and over time towards a target. Insiders under-invest in production and effort so as not to unduly raise outsiders' expectations about future income, a problem that is more severe the smaller is the inside ownership and results in an 'outside equity Laffer curve'. A disclosure environment with adequate quality of independent auditing mitigates the problem, implying that accounting quality can enhance investments, size of public stock markets and economic growth.
    Keywords: accounting quality; asymmetric information; measurement error; payout policy; under-investment
    JEL: D82 D92 G32 G35 M41 M42 O43
    Date: 2012–01
  7. By: Bijlsma, Michiel; Boone, Jan; Zwart, Gijsbert
    Abstract: The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks' remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank's top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labour market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks' capital requirements does not unambiguously lead to reduced risk-taking by their top traders.
    Keywords: financial institutions; imperfect competition; optimal contracts; remuneration policy; risk
    JEL: G21 G32 L22
    Date: 2012–02
  8. By: Hakenes, Hendrik; Schnabel, Isabel
    Abstract: This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bail-outs. If there is a risk-shifting problem, bail-out expectations lead to steeper bonus schemes and even more risk-taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bail-out perceptions makes it optimal for a welfare-maximizing regulator to impose caps on bank bonuses. In contrast, raising managers’ liability is counterproductive.
    Keywords: bank bail-outs; bank management compensation; bonus payments; limited and unlimited liability; risk-shifting; underinvestment
    JEL: G21 G28 J33 M52
    Date: 2012–02
  9. By: Hideo Hashimoto (Osaka University); Kojun Hamada (Niigata University); Nobuhiro Hosoe (National Graduate Institute for Policy Studies)
    Abstract: By building and solving numerical models of the parts supply problems (an example of the adverse selection problems), and analyzing various issues of the contract theory, we demonstrate the benefits of the numerical approach. First, this approach facilitates the understanding of the contract theory by beginners, who find it difficult to comprehend the theoretical and general models. Second, this approach could extend the analysis areas beyond those of the theoretical models, which are limited by the simplifying assumptions imposed in order to make their analysis possible. The expansion of the number of the supplier types is one example.
    Keywords: Numerical approach; principal-agent problem; adverse selection; numerical and computational model; Spence-Mirrlees single crossing property; monotonicity
    Date: 2012–03
  10. By: Alger, Ingela; Weibull, Jörgen
    Abstract: What preferences will prevail in a society of rational individuals when preference evolution is driven by their success in terms of resulting payoffs? We show that when individuals’ preferences are their private information, a convex combinations of selfishness and morality stand out as evolutionarily stable. We call individuals with such preferences homo moralis. At one end of the spectrum is homo oeconomicus, who acts so as to maximize his or her material payoff. At the opposite end is homo kantiensis, who does what would be “the right thing to do,” in terms of material payoffs, if all others would do likewise. We show that the stable degree of morality - the weight placed on the moral goal - equals the index of assortativity in the matching process. The motivation of homo moralis is arguably compatible with how people often reason, and the induced behavior agrees with pro-social behaviors observed in many laboratory experiments.
    JEL: C73 D03
    Date: 2012–02
  11. By: Gersbach, Hans; Rochet, Jean-Charles
    Abstract: Evidence suggests that banks tend to lend a lot during booms, and very little during recessions. We propose a simple explanation for this phenomenon. We show that, instead of dampening productivity shocks, the banking sector tends to exacerbate them, leading to excessive fluctuations of credit, output and asset prices. Our explanation relies on three ingredients that are characteristic of modern banks' activities. The first ingredient is moral hazard: banks are supposed to monitor the small and medium sized enterprises that borrow from them, but they may shirk on their monitoring activities, unless they are given sufficient informational rents. These rents limit the amount that investors are ready to lend them, to a multiple of the banks' own capital. The second ingredient is the banks' high exposure to aggregate shocks: banks' assets have positively correlated returns. Finally the third ingredient is the ease with which modern banks can reallocate capital between different lines of business. At the competitive equilibrium, banks offer privately optimal contracts to their investors but these contracts are not socially optimal: banks' decisions of reallocating capital react too strongly to aggregate shocks. This is because banks do not internalize the impact of their decisions on asset prices. This generates excessive fluctuations of credit, output and asset prices. We examine the efficacy of several possible policy responses to these properties of credit markets, and derive a rationale for macroprudential regulation.
    Keywords: Bank Credit Fluctuations; Investment Externalities; Macroprudential Regulation
    JEL: D86 G21 G28
    Date: 2012–01
  12. By: Auriol, Emmanuelle; Friebel, Guido; Lammers, Frauke
    Abstract: We suggest a parsimonious dynamic agency model in which workers have status concerns. A firm is a promotion hierarchy in which a worker’s status depends on past performance. We investigate the optimality of two types of promotion hierarchies: (i) internal labor markets, in which agents have a job guarantee, and (ii) 'up-or-out', in which agents are fired when unsuccessful. We show that up-or-out is optimal if success is difficult to achieve. When success is less hard to achieve, an internal labor market is optimal provided the payoffs associated with success are moderate. Otherwise, up-or-out is, again, optimal. These results are in line with observations from academia, law firms, investment banks and top consulting firms. Here, up-or-out dominates, while internal labor markets dominate where work is less demanding or payoffs are more compressed, for instance, because the environment is less competitive. We present some supporting evidence from academia, comparing US with French economics departments.
    Keywords: Incentives; Promotion hierarchies; Sorting; Status
    JEL: J3 L2 M5
    Date: 2012–02
  13. By: Wagner, Robert; Zwick, Thomas
    Abstract: This paper jointly analyses the consequences of adverse selection and signalling on entry wages of skilled employees. It uses German linked employer employee panel data (LIAB) and introduces a measure for relative productivity of skilled job applicants based on apprenticeship wages. It shows that post-apprenticeship employer changers are a negative selection from the training firms' point of view. Negative selection leads to lower average wages of employer changersin the first skilled job in comparison to stayers. Entry wages of employer changers are specifically reduced by high occupation and training firm retention rates. Additional training firm signals are high apprenticeship wages that signal a positive selection of apprenticeship applicants, works councils and establishment size. Finally, positive individual signals such as schooling background affect the skilled entry wages of employer changers positively. --
    Keywords: entry wages,employer change,adverse selection,signalling
    JEL: J24 J31 J62 J63 M52 M53
    Date: 2012
  14. By: Lippi, Francesco; Trachter, Nicholas
    Abstract: We characterize policies for the supply of liquidity in an economy where agents have a precautionary savings motive due to random production opportunities and the presence of borrowing constraints. We show that a socially efficient provision of liquidity involves a trade-off between insurance and production incentives. Two scenarios are studied: if no aggregate information is available to the policy maker, constant flat expansions are socially beneficial if unproductive spells are sufficiently long. If some aggregate information is available, a socially beneficial state-dependent policy prescribes expanding the supply of liquidity in recessions and contracting it in expansions.
    Keywords: Friedman rule; Heterogenous agents; Incomplete markets; Liquidity; Precautionary savings; State dependent policy.
    JEL: E5
    Date: 2012–03
  15. By: Bigoni, Maria; Potters, Jan; Spagnolo, Giancarlo
    Abstract: Flexibility - the ability to react swiftly to others' choices - facilitates collusion by reducing gains from defection before opponents react. Under imperfect monitoring, however, flexibility may also hinder collusion by inducing punishment after too few noisy signals. The combination of these forces predicts a non-monotonic relationship between flexibility and collusion. To test this subtle prediction we implement in the laboratory an indefinitely repeated Cournot game with noisy price information and vary how long players have to wait before changing output. We find that (i) the facilitating role of flexibility is lost under imperfect monitoring, and (ii) with learning, collusion unravels with low or high flexibility, but not with intermediate flexibility.
    Keywords: Collusion; Cooperation; Flexibility; Imperfect monitoring; Oligopoly; Repeated games.
    JEL: C73 C92 D43 L13 L14
    Date: 2012–03
  16. By: Lagerlöf, Johan N. M.
    Abstract: Although naive intuition may indicate the opposite, the existing literature suggests that uncertainty about costs in the homogeneous-good Bertrand model intensifies competition: it lowers price and raises total surplus (but also makes profits go up). Those results, however, are derived under two assumptions that, if relaxed, conceivably could reverse the results. The present paper first shows that the results hold also if drastic innovations are possible. Next, the paper assumes asymmetric cost distributions, a possibility that is empirically highly plausible but which has been neglected in the previous literature. Using numerical methods it is shown that, under this assumption, uncertainty lowers price and raises total surplus even more than with identical distributions. However, if the asymmetry is large enough, industry profits are lower under uncertainty; this is in contrast to the known results and reinforces the notion that uncertainty intensifies competition rather than softens it.
    Keywords: asymmetric auctions; asymmetric firms; auctions with endogenous quantity; Bertrand competition; boundary value method; Hansen-Spulber model; information sharing; oligopoly; private information
    JEL: D43 D44 L13
    Date: 2012–02
  17. By: Acharya, Viral V; Naqvi, Hassan
    Abstract: We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, to induce effort, loan officers are compensated based on the volume of loans. Volumebased compensation also induces greater risk-taking; however, due to lack of commitment, loan officers are penalized ex post only if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This ‘flight to quality’ leaves banks flush with liquidity, lowering the sensitivity of bankers’ payoffs to downside risks and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown.
    Keywords: bubbles; flight to quality; moral hazard
    JEL: E32 G21
    Date: 2012–02
  18. By: Anderson, Simon P.; Renault, Régis
    Abstract: We extend the persuasion game to bring it squarely into the economics of advertising. We model advertising as exciting consumer interest into learning more about the product, and determine a firm's equilibrium choice of advertising content over quality information, price information, and horizontal match information. Equilibrium is unique whenever advertising is necessary. The outcome is a separating equilibrium with quality unravelling. Lower quality firms need to provide more information. For a given quality level, as a function of consumer visit costs, first quality information is disclosed, then price information and then horizontal product information are added to the advertising mix. Some suggestive evidence is provided from airline ads in newspapers.
    Keywords: advertising; content analysis; information; persuasion game; search
    JEL: D42 L15 M37
    Date: 2012–01
  19. By: Pier-André Bouchard St-Amant (Queen's Economics Department)
    Abstract: I develop a theoretical framework for studying viral communications through a principal agent set-up. The principal derives wealth from a signal in a society while agents in the society talk to each other. A society is likely to create a viral bubble if there is a short loop of positive reinforcement of the message. If the society is in a steady state or if the principal is impatient, she is more likely to use widespread marketing strategies yielding a weaker effect. If the society is out of the steady-state and if she is patient, she will however prefer a viral communication strategy with stronger effects. All in all, the model suggests that the way information is spread matters in transitionary dynamics of an economy. Examples of applications are straight marketing campaigns on a web network, optimal announcement rules for central banks as well as a new framework to understand economic fluctuations.
    Keywords: Networks, Viral Communication
    JEL: D83 D85
    Date: 2012–03

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