nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2012‒07‒23
fourteen papers chosen by
Simona Fabrizi
Massey University, Albany

  1. The Tenuous Relationship between Effort and Performance Pay By Kvaløy, Ola; Olsen, Trond E.
  2. Solving Two Sided Incomplete Information Games with Bayesian Iterative Conjectures Approach By Teng, Jimmy
  3. Genetic testing with primary prevention and moral hazard By David Bardey; Philippe De Donder
  4. Honesty, lemons, and symbolic signals By Jorge M. Streb; Gustavo Torrens
  5. A Political Winner’s Curse: Why Preventive Policies Pass Parliament so Narrowly By Philipp an de Meulen; Christian Bredemeier
  6. Market Thickness, Prices and Honesty: A Quality Demand Trap By Siddhartha Bandyopadhyay
  8. Inefficiency in the Shadow of Unobservable Outside Options By Madhav S. Aney
  9. Reducing overreaction to central banks' disclosures:theory and experiment By Romain Baeriswyl; Camille Cornand
  10. Taming SIFIs By Xavier Freixas; Jean-Charles Rochet
  11. The hold-up problem, innovations, and limited liability By Schmitz, Patrick W
  12. Duality in Contracting By Peter Bardsley
  13. Incentives to Motivate By Kvaløy, Ola; Schöttner, Anja
  14. The Design of Ambiguous Mechanisms By Alfredo Di Tillio; Nenad Kos; Matthias Messner

  1. By: Kvaløy, Ola (UiS Business School, University of Stavanger); Olsen, Trond E. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
    Abstract: When a worker is offered performance related pay, the incentive effect is not only determined by the shape of the incentive contract, but also by the probability of contract enforcement. We show that weaker enforcement may reduce the worker's effort, but lead to higher-powered incentive contracts. This creates a seemingly negative relationship between effort and performance pay.
    Keywords: Effort; performance pay; incentive contract
    JEL: J30
    Date: 2012–07–10
  2. By: Teng, Jimmy
    Abstract: This paper proposes a way to solve two (and multiple) sided incomplete information games which generally generates a unique equilibrium. The approach uses iterative conjectures updated by game theoretic and Bayesian statistical decision theoretic reasoning. Players in the games form conjectures about what other players want to do, starting from first order uninformative conjectures and keep updating with games theoretic and Bayesian statistical decision theoretic reasoning until a convergence of conjectures is achieved. The resulting convergent conjectures and the equilibrium (which is named Bayesian equilibrium by iterative conjectures) they supported form the solution of the game. The paper gives two examples which show that the unique equilibrium generated by this approach is compellingly intuitive and insightful. The paper also solves an example of a three sided incomplete information simultaneous game.
    Keywords: new equilibrium concept; two and multiple sided incomplete information; iterative conjectures; convergence; Bayesian decision theory; Schelling point
    JEL: C70 C72
    Date: 2012–03–01
  3. By: David Bardey; Philippe De Donder
    Abstract: We develop a model where a genetic test reveals whether an individual has a low or high probability of developing a disease. A costly prevention effort allows high-risk agents to decrease this probability. Agents are not obliged to take the test, but must disclose its results to insurers, and taking the test is associated to a discrimination risk. We study the individual decisions to take the test and to undertake the prevention effort as a function of the effort cost and of its efficiency. If effort is observable by insurers, agents undertake the test only if the effort cost is neither too large nor too low. If the effort cost is not observable by insurers, moral hazard increases the value of the test if the effort cost is low. We offer several policy recommendations, from the optimal breadth of the tests to policies to do away with the discrimination risk.
    Date: 2012–07–13
  4. By: Jorge M. Streb; Gustavo Torrens
    Abstract: Under asymmetric information, dishonest sellers lead to market unraveling in the lemons model. An additional cost of dishonesty is that language becomes cheap talk. We develop instead a model where people derive utility from actions (what they say), as well as from outcomes, so talk is costly. We find that the existence of honest agents that mean what they say is not enough to make trade more likely, unless a traceability condition that prevents arbitrage is met. When we introduce a continuum of misrepresentation cost types and qualities, full market unraveling is not possible and babbling equilibria are eliminated. More generally, costly talk is a special kind of signal, a symbolic signal that presupposes linguistic conventions, otherwise truth and falsehood, as well as misrepresentation costs, are undefined.
    Keywords: asymmetric information, honesty, trust, symbols, signals, costly talk
    JEL: D8 C7
    Date: 2012–07
  5. By: Philipp an de Meulen; Christian Bredemeier
    Abstract: Preventive policy measures such as bailouts often pass parliament very narrowly. We present a model of asymmetric information between politicians and voters which rationalizes this narrow parliamentary outcome. A successful preventive policy impedes the verification of its own necessity. When policy intervention is necessary but voters disagree ex-ante, individual politicians have an incentive to loose the vote in parliament in order to be rewarded by voters ex-post. Comfortable vote margins induce incentives to move to the loosing fraction to avoid this winner’s curse. In equilibrium, parliamentary elections over preventive policies are thus likely to end at very narrow margins.
    Keywords: Political economy; asymmetric information
    JEL: D72 D82
    Date: 2012–05
  6. By: Siddhartha Bandyopadhyay
    Abstract: We analyze how product quality, prices and demand interact in a dynamic model of asymmetric information. We show that in markets for experience goods, even in the absence of certification, trade may occur, arising from a relation between market thickness and the incentive of sellers to produce high quality. We characterize the equilibrium prices, which depend on the distribution of buyer valuations. Finally, we show that the relationship between market thickness and incentive to produce high quality goods exists up to a certain threshold level of demand.
    Keywords: Market Thickness, Endogenous Quality, Multiple Equilibria, Price Mechanism
    JEL: L14 L15 O12 O17
    Date: 2012–07
  7. By: Michael Kopel (University of Graz); Marco Marini (La Sapienza University)
    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 profit- maximizing 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.
    Keywords: Consumer Cooperatives, Strategic Incentives, Price Competition, Oligopoly.
    JEL: C70 C71 D23 D43
    Date: 2012
  8. By: Madhav S. Aney (School of Economics, Singapore Management University)
    Abstract: This paper considers the problem of allocating an object between two players in an environment with one sided asymmetric information when their outside options depend on each other's type, causing the outside option of the uninformed player to be unobservable to her. Consequently efficient mechanisms under budget balance are not always available even when there is no uncertainty about which of the two players values the object more. A simple condition on the outside options turns out to be both necessary and sufficient to guarantee the first best. I also characterise the second best allocation under some conditions and show how it varies with changes in the outside options. I argue that the model applies to an environment where property rights over the object are not well defined and their enforcement is subject to an inefficient default game such as a contest. In such cases type dependent outside options arise naturally as the equilibrium payos from the default game. The model can explain why the best ways of avoiding inefficient default games, such as arbitration as a way of avoiding litigation, typically involve a degree of inefficiency.
    Date: 2012–07
  9. By: Romain Baeriswyl; Camille Cornand
    Abstract: Financial markets are known for overreacting to public information. Central banks can reduce this overreaction either by disclosing information to a fraction of market participants only (partial publicity) or by disclosing information to all participants but with ambiguity (partial transparency). We show that, in theory, both communication strategies are strictly equivalent in the sense that overreaction can be indifferently mitigated by reducing the degree of publicity or by reducing the degree of transparency. We run a laboratory experiment to test whether theoretical predictions hold in a game played by human beings. In line with theory, the experiment does not allow the formulation of a clear preference in favor of either communication strategy. This paper then discusses the opportunity for central banks to choose between partial transparency and partial publicity to control market reaction to their disclosures.
    Keywords: heterogeneous information, public information, overreaction, transparency,coordination, experiment
    JEL: C92 D82 D84 E58
    Date: 2012
  10. By: Xavier Freixas; Jean-Charles Rochet
    Abstract: We model a Systemically Important Financial Institution (SIFI) that is too big (or too interconnected) to fail. Without credible regulation and strong supervision, the shareholders of this institution might deliberately let its managers take excessive risk. We propose a solution to this problem, showing how insurance against systemic shocks can be provided without generating moral hazard. The solution involves levying a systemic tax needed to cover the costs of future crises and more importantly establishing a Systemic Risk Authority endowed with special resolution powers, including the control of bankers' compensation packages during crisis periods.
    Keywords: SIFI, dynamic moral hazard, risk taking
    JEL: G21 G32 G34
    Date: 2012–06
  11. By: Schmitz, Patrick W
    Abstract: An inventor can invest research effort to come up with an innovation. Once an innovation is made, a contract is negotiated and unobservable effort must be exerted to develop a product. In the absence of liability constraints, the inventor's investment incentives are increasing in his bargaining power. Yet, given limited liability, overinvestments may occur and the inventor's investment incentives may be decreasing in his bargaining power.
    Keywords: hold-up problem; incomplete contracts; limited liability; research and development
    JEL: D86 L23 O31
    Date: 2012–07
  12. By: Peter Bardsley
    Abstract: In a linear contracting environment the Fenchel transform provides a complete duality between the contract and the information rent. Through an appropriate generalised convexity this can be extended to provide a complete duality in the supermodular quasilinear contracting environment that covers the majority of applications. Using this framework, we provide a complete characterization of the allocation correspondences that can be implemented by a principal in this environment. We also address the question of when an allocation can be implemented by a menu of simple contracts. Along the way, a supermodular envelope theorem is proved, somewhat different in nature to the Milgrom Segal result.
    Keywords: mechanism design; contract theory; duality; Fenchel transform; abstract convexity
    JEL: D82 D86
    Date: 2012
  13. By: Kvaløy, Ola (UiS); Schöttner, Anja (University of Bonn)
    Abstract: We present a model in which a motivator can take costly actions - or what we call motivational effort - in order to reduce the effort costs of a worker, and analyze the optimal combination of motivational effort and monetary incentives. We distinguish two cases. First, the firm owner chooses the intensity of motivation and bears the motivational costs. Second, another agent of the firm chooses the motivational actions and incurs the associated costs. In the latter case, the firm must not only incentivize the worker to work hard, but also the motivator to motivate the worker. We characterize and discuss the conditions under which monetary incentives and motivational effort are substitutes or complements, and show that motivational effort may exceed the efficient level.
    Keywords: Incentives; Motivate
    JEL: A10
    Date: 2012–07–17
  14. By: Alfredo Di Tillio; Nenad Kos; Matthias Messner
    Abstract: This paper considers the optimal mechanism design problem of an expected revenue maximizing principal who wants to sell a single unit of a good to an agent who is ambiguity averse in the sense of Gilboa and Schmeidler (1989). We show that the optimal static mechanism is an ambiguous mechanism. An ambiguous mechanism specifies a message space and a set of outcome functions. After showing that (a version of) the Revelation Principle holds in our environment, we give an exact characterization of the (smallest) optimal ambiguous mechanism. If the type set is composed of N (finite) types, then the (smallest) optimal ambiguous mechanism contains N - 1 outcome functions. We show that the share of the surplus that the designer can extract from the agent increases as the type set becomes larger and the probability of each single type decreases. In the limiting case where the agent’s type is drawn from a non-atomic distribution on an interval, the optimal ambiguous mechanism extracts all the rent from the agent.
    Date: 2012

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