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on Contract Theory and Applications |
| By: | Glenn Pfeiffer (Argyros School of Business and Economics, Chapman University, USA); Timothy Shields (Argyros School of Business and Economics, Chapman University, USA) |
| Abstract: | Motivated by research reporting positive price reactions to adoption of performance-based compensation plans, we examine price reactions to compensation contracting in experimental markets. The design allows us to manipulate variables separately and study issues of adverse selection (sorting) and moral hazard (incentives). We find that managers select contracts based on their private information, and that information is conveyed to the market by the choice of compensation contract and reflected in price. Additionally, we find that managers do not always exert costly effort in spite of favorable incentives to do so (shirking). As a result, the market is skeptical of incentive benefits. Thus, while we find evidence of overbidding in some treatments, we find that market prices are consistent with private information revelation but undervalue incentive benefits. |
| Keywords: | compensation, experimental markets, sorting, incentives |
| JEL: | C92 D82 G12 J33 M52 |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:chu:wpaper:12-17&r=cta |
| By: | Shawn Cole (Harvard Business School, Finance Unit); Martin Kanz (World Bank); Leora Klapper (World Bank) |
| Abstract: | This paper uses a series of experiments with commercial bank loan officers to test the effect of performance incentives on risk-assessment and lending decisions. We first show that, while high-powered incentives lead to greater screening effort and more profitable lending, their power is muted by both deferred compensation and the limited liability typically enjoyed by credit officers. Second, we present direct evidence that incentive contracts distort judgment and beliefs, even among trained professionals with many years of experience. Loans evaluated under more permissive incentive schemes are rated significantly less risky than the same loans evaluated under pay-for-performance. |
| Keywords: | loan officer incentives, banking, emerging markets |
| JEL: | D03 G21 J22 J33 L2 |
| Date: | 2012–07 |
| URL: | http://d.repec.org/n?u=RePEc:hbs:wpaper:13-002&r=cta |
| By: | Emre Ozdenoren; Kathy Yuan |
| Abstract: | We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of _rms. Each _rm's manager exerts costly hidden e_ort. The productivity of e_ort is subject to systematic shocks. Firms' stock prices reect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial e_ort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average e_ort. During booms, they over-incentivise managers, triggering a rat-race in e_ort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts. |
| Date: | 2012–07 |
| URL: | http://d.repec.org/n?u=RePEc:fmg:fmgdps:dp706&r=cta |
| By: | Waldyr Areosa; Marta Areosa |
| Abstract: | We examine exchange-rate pass-through (ERPT) to prices in a model of dispersed information in which the nominal exchange rate imperfectly conveys information about the underlying fundamentals. If the information is complete, ERPT is also complete. Under dispersed information, we derive conditions under which our model displays three properties that are consistent with the stylized facts of pass-through. First, ERPT lies between 0 and 1 (incomplete ERPT). Second, ERPT is usually higher for imported goods prices than for consumer prices (exchange rate-consumer price puzzle). Third, there is a link between ERPT and macroeconomic stability. |
| Date: | 2012–06 |
| URL: | http://d.repec.org/n?u=RePEc:bcb:wpaper:282&r=cta |
| By: | Efthymios Athanasiou (Dep. of Philosophy, CMU); Santanu Dey (ISYE, Georgia Tech); Giacomo Valleta (Dep. of Economics, Maastricht) |
| Abstract: | We put forward a model of private goods with externalities. Agents derive benefit from communicating with each other. In order to communicate they need to have a language in common. Learning languages is costly. In this setting no individually rational and feasible Groves mechanism exists. We characterize the best-in-class feasible Groves mechanism and the best-in-class individually rational Groves mechanism. |
| Keywords: | Groves Mechanisms, Externality, Budget Surplus or Deficit, Pareto Undominated Mechanisms |
| JEL: | D70 D62 C60 |
| Date: | 2012–05 |
| URL: | http://d.repec.org/n?u=RePEc:fem:femwpa:2012.41&r=cta |
| By: | Germán Coloma |
| Abstract: | This paper presents a model of the penalty-kick game between a soccer goalkeeper and a kicker, in which there is uncertainty about the kicker’s type (and there are two possible types of kicker). To find a solution for this game we use the concept of Bayesian equilibrium, and we find that, typically, one of the kicker’s types will play a mixed strategy while the other type will choose a pure strategy (or, sometimes, a “restricted mixed strategy”). The model has a simpler version in which the players can only choose between two strategies (right and left), and a more complex version in which they can also choose a third strategy (the center of the goal). Comparing the incomplete-information Bayesian equilibria with the corresponding complete-information Nash equilibria, we find that in all cases the expected scoring probability increases (so that, on average, the goalkeeper is worse off under incomplete information). The three-strategy model is also useful to explain why it could be optimal for a goal keeper never to choose the center of the goal (although at the same time there were some kickers who always chose to shoot to the center). |
| Keywords: | soccer penalty kicks, mixed strategies, Bayesian equilibrium, incomplete information |
| JEL: | C72 L83 |
| Date: | 2012–05 |
| URL: | http://d.repec.org/n?u=RePEc:cem:doctra:487&r=cta |
| By: | Thomas J. Chemmanur; Viktar Fedaseyeu |
| Abstract: | We develop a theory of corporate boards and their role in forcing CEO turnover. We consider a firm with an incumbent CEO of uncertain management ability and a board consisting of a number of directors whose role is to evaluate the CEO and fire her if a better replacement can be found. Each board member receives an independent private signal about the CEO's ability, after which board members vote on firing the CEO (or not). If the CEO is fired, the board hires a new CEO from the pool of candidates available. The true ability of the rm's CEO is revealed in the long run; the firm's long-run share price is determined by this ability. Each board member owns some equity in the firm, and thus prefers to fire a CEO of poor ability. However, if a board member votes to fire the incumbent CEO but the number of other board members also voting to fire her is not enough to successfully oust her, the CEO can impose significant costs of dissent on him. In this setting, we show that the board faces a coordination problem, leading it to retain an incompetent CEO even when a majority of board members receive private signals indicating that she is of poor quality. We solve for the optimal board size, and show that it depends on various board and rm characteristics: one size does not fit all firms. We develop extensions to our basic model to analyze the optimal composition of the board between firm insiders and outsiders and the effect of board members observing imprecise public signals in addition to their private signals on board decision-making. Finally, we develop a dynamic extension to our basic model to analyze why many boards do not fire CEOs even when they preside over a signicant, publicly observable, reduction in shareholder wealth over a long period of time. We use this dynamic model to distinguish between the characteristics of such boards from those that fire bad CEOs proactively, before significant shareholder wealth reductions take place. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:igi:igierp:444&r=cta |
| By: | Michael Kopel (Institute of Organization and Economics of Institutions, University of Graz); Marco A. Marini (Department of Computer, Control and Management Engineering, Sapienza Università di Roma) |
| Abstract: | The main aim of this paper is to derive properties of an optimal compensation scheme for consumer cooperatives (Coops) in situations of strategic interaction with profitmaximizing firms (PMFs). Our model provides a reason why Coops are less prone than PMFs to pay variable bonuses to their managers. We show that this occurs under price competition when in equilibrium the Coop prefers to pay a straight salary to its manager whereas the profit-maximizing rival adopts a variable, high-powered incentive scheme. The main rationale is that, due to consumers’ preferences, a Coop is per se highly expansionary in term of output and, therefore, does not need to provide strong strategic incentives to their managers to expand output aggressively by undercutting its rival. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:aeg:wpaper:2012-6&r=cta |
| By: | Matteo Bassi (Università di Napoli Federico II and CSEF) |
| Abstract: | This paper studies the optimal fiscal treatment of addictive goods (cigarettes, drugs, fatty foods, alcohol, gambling etc.). It shows that, when agents have private information about their productivity levels and their degree of rationality, the Atkinson and Stiglitz result of optimal uniform commodity taxation does not hold: addictive and non-addictive goods should be taxed at different rates. Depending on the direction of redistribution, the addictive good should be taxed more or less than the non-addictive good. Differential commodity taxation is not driven by the planner’s paternalism, but only by incentive considerations. A tax authority which fully respects consumers’ sovereignty taxes the consumption of addictive and non-addictive goods at different rates to improve screening of types and increase income redistribution. |
| Keywords: | Bounded Rationality, Optimal Taxation, Minimal Paternalism, Multidimensional Screening |
| JEL: | A12 D91 E21 H55 |
| Date: | 2012–07–05 |
| URL: | http://d.repec.org/n?u=RePEc:sef:csefwp:317&r=cta |
| By: | Cesare Dosi (Department of Economics and Management, University of Padova); Michele Moretto (Department of Economics and Management, University of Padova, Centro Studi Levi Cases, Fondazione Eni Enrico Mattei) |
| Abstract: | Time overruns are common in public works and are not confined to inherently complex tasks. One explanation advanced in this paper is that bidders can undergo unpredictable changes in production costs which generate an option value of waiting. By exploiting the real-option approach, we examine how the inability to force sellers to meet the contract time influences their bidding behaviour, and how this can ultimately affect the parties’ expected payoffs. Further, we examine the outcome of the bidding process when legal rules prevent the promisee from contracting for damage measures which would grant more than her lost expectation. We show that when the pre-agreed compensatory payments prove insufficient to discourage delayed orders, setting a liquidated damages clause would not lead to a Pareto superior outcome with respect to the no-damage-for delay condition. While such a clause would increase the seller’s expected payoff, the buyer’s expected payoff is lower than when the contract does not provide for any compensation for late-delivery. |
| Keywords: | Public Procurement, Fixed-Price Contracts, Cost Uncertainty, Time Overruns, Liquidated Damages, Real Options |
| JEL: | C61 D44 D86 K12 |
| Date: | 2012–06 |
| URL: | http://d.repec.org/n?u=RePEc:fem:femwpa:2012.45&r=cta |
| By: | Nicola Dimitri (Department of Economics and Statistics, University of Sienna, and Research Fellow, Maastricht School of Management) |
| Abstract: | In the Italian Football League rights to a player’s performance could be co-owned by two clubs for one year. Co-ownership must then be resolved and if the clubs fail finding an agreement they are asked by the League to participate to an auction, where each of them submits a price offer for the missing half of the rights. The player offering the highest price obtains the missing half of the rights paying that price to the opponent. In the paper we characterize the auction equilibrium structure with both complete and incomplete information. Due to its features, a main finding in such auction is that “losers” can obtain a higher payoff than “winners”, and in this sense be the real winners. Then, by considering the auction as a more general mechanism for co-ownership resolution, we extend the model to any finite number of players and argue how some of the results with two players do not necessarily generalize. In particular, while with two players the equilibrium expected payoffs can never be negative this may not be so with a higher number of players. Finally, also with incomplete information the symmetric bidding equilibrium function with any finite number of players is in the “winning losers” spirit. Indeed, bids range between one’s value and twice of it, and increase with the number of players since it becomes more likely that some opponent will have a higher value. |
| Date: | 2012–07 |
| URL: | http://d.repec.org/n?u=RePEc:msm:wpaper:2012/08&r=cta |
| By: | Miguel Vazquez |
| Abstract: | Absence of arbitrage is one of the fundamental tools to describe financial markets. The no-arbitrage price of any financial contract represents players’ valuation of the uncertain future income stream that will result from the contract. This reasoning is based on considering future income streams as exogenously defined variables. When spot markets do not behave under the assumption of perfect competition, future income streams might depend on players’ strategies. If this is the case, price differences between the forward and the spot markets do not imply the existence of arbitrage opportunities, as market players cannot take advantage of such differences. The paper will study the forward-spot interaction in the presence of spot market power. It will be shown that, when producers anticipate that forward sales reduce spot price, they can react in the forward market to compensate for the spot price decrease. Hence, players profits are, considering both forward and spot markets, equivalent to the ones obtained in the case where no forward trading is allowed. The paper also develops a multi-period model that considers the role of private information, aimed to represent that past spot prices are signals of the probability of future spot prices. In this context, there is an additional incentive when playing in the spot market, which is associated with the sensitivity of forward prices to past spot decisions. This often results in spot prices equal to the ones obtained in the no-trade case. The policy implications of the previous results will be discussed. Actually, it will be shown that the number of regulatory measures based on forward contracting that can be used to mitigate market power is considerably small. |
| Keywords: | Forward markets; oligopoly; private information |
| Date: | 2012–03–09 |
| URL: | http://d.repec.org/n?u=RePEc:rsc:rsceui:2012/13&r=cta |