nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒01‒26
fifteen papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Who Gains from Information Asymmetry? By Gil S. Epstein; Yosef Mealem
  2. The Perverse Incentive of Knowing the Truth By Garcia-Martinez, Jose A.
  3. North / South Contractual Design through the REDD+ Scheme By Mireille Chiroleu-Assouline; Jean-Christophe Poudou; Sébastien Roussel
  4. Use and abuse of authority: A behavioral foundation of the employment relation By Björn Bartling; Ernst Fehr; Klaus M. Schmidt
  5. Building Reputation for Contract Renewal: Implications for Performance Dynamics and Contract Duration By Iossa, Elisabetta; Rey, Patrick
  6. Multiple Lenders, Strategic Default and Debt Covenants By Andrea Attar; Catherine Casamatta; Arnold Chassagnon; Jean Paul Décamps
  7. Mergers in Bidding Markets By Maarten Janssen; Vladimir Karamychev
  8. The lure of authority: Motivation and incentive effects of power By Ernst Fehr; Holger Herz; Tom Wilkening
  9. The optimality of heterogeneous tournaments By Gürtler, Marc; Gürtler, Oliver
  10. Dynamic Prudential Regulation By Afrasiab Mirza
  11. Dying to Retire: Adverse Selection and Welfare in Social Security By Andrew Beauchamp; Mathis Wagner
  12. The Implications of VaR and Short-Selling Restrictions on the Portfolio Manager Performance By Fulbert, Tchana Tchana; Georges, Tsafack
  13. Too big to cheat: efficiency and investment in partnerships By Emilio Espino; Julian Kozlowski; Juan M. Sánchez
  14. Financing constraints, firm dynamics, and international trade By Stephane Verani; Till Gross
  15. Reputation and Entry By Jeffrey V. Butler; Enrica Carbone; Pierluigi Conzo; Giancarlo Spagnolo

  1. By: Gil S. Epstein (Bar-Ilan University); Yosef Mealem
    Abstract: This article considers an asymmetric contest with incomplete information. There are two types of players: informed and uninformed. Each player has a different ability to translate effort into performance in terms of the contest success function. While one player's type is known to both players, the other is private information and known only to the player himself. We compare the Bayesian Nash equilibrium outcome of a one-sided private information contest to the Nash equilibrium with no private information, in which both players know the type of the other player. We show conditions under which uncertainty increases the investment of the uninformed player and the rent dissipation of the contest, while decreasing the expected net payoff of the informed player. In addition, we consider conditions under which the informed player – before knowing his own type – prefers that the uninformed player knows his type. Moreover, we show conditions for the existence/non-existence of equilibrium in a two-stage contest in which the informed player declares his type (or does not declare) in the first stage and in the second stage the two players play according to the information available to them.
    Keywords: Asymmetric contests, rent seeking, incomplete information
    JEL: D72 C72
    Date: 2013–01
  2. By: Garcia-Martinez, Jose A.
    Abstract: We show that the observation by a principal of the effectiveness of an expert‘s action could induce the expert to lie, damaging the principal. A career-minded expert receives a private-informative signal about the real state of the world, and then he takes an action that can match or not the real state. If a principal observes the consequences of this expert’s action, i.e., if the action matches or not the real state, this expert could disregard his valuable information damaging the principal: the expert plays the opposite action to that recommended by his signal and consequently decreases the probability of matching the real state. However, this expert could play the "recommended" action with positive probability if consequences are not observed. The previous literature has found that "transparency of consequence" can only improves the incentives of the expert to reveal his valuable information. The paradoxical behavior we have found can appear when the expert needs to signal with one action two different kinds of information, and there is a particular "trade-off" in the way of signaling; this "trade-off" can be affected in an unexpected way by the observation of the expert’s action consequences. In this paper, we present a simple model to capture this idea, and characterize the range of the parameters where that occurs.
    Keywords: Transparency; Principal-Agent; Reputation
    JEL: D82 C72
    Date: 2013–01–15
  3. By: Mireille Chiroleu-Assouline (Paris School of Economics (PSE) - Université Paris 1 Panthéon-Sorbonne, Centre d'Economie de la Sorbonne); Jean-Christophe Poudou (Université Montpellier 1, UMR5474 LAMETA); Sébastien Roussel (Université Montpellier 3 Paul Valéry & Université Montpellier 1, UMR5474 LAMETA)
    Abstract: In this paper we aim at theoretically grounding the Reducing Emissions from Deforestation and Forest Degradation + (REDD+) scheme as a contractual relationship between countries in the light of the theory of incentives. Considering incomplete information about reference levels of deforestation as well as exogenous implementation and transaction costs, we compare two types of contracts: a deforestation performance-based contract and a conditional avoided deforestation-based contract. Because of the implementation and transaction costs, each kind of REDD+ contract implies a dramatically different information rent/efficiency trade-off. If the contract is performance-based (resp. conditionality-based), information rents are awarded to countries with the ex ante lowest (resp. highest) deforestation. In a simple quadratic setting, there is a reference level threshold in terms of efficiency towards less deforestation. In terms of expected welfare, conditional avoided deforestation-based schemes are preferred.
    Keywords: Conditionality, Contract, Deforestation, Hidden Information, Incentives, Performance, Reducing Emissions from Deforestation and Forest Degradation + (REDD+)
    JEL: D82 O13 Q23 Q54
    Date: 2012–11
  4. By: Björn Bartling; Ernst Fehr; Klaus M. Schmidt
    Abstract: Employment contracts give a principal the authority to decide flexibly which task his agent should execute. However, there is a tradeoff, first pointed out by Simon (1951), between flexibility and employer moral hazard. An employment contract allows the principal to adjust the task quickly to the realization of the state of the world, but he may also abuse this flexibility to exploit the agent. We capture this tradeoff in an experimental design and show that principals exhibit a strong preference for the employment contract. However, selfish principals exploit agents in one-shot interactions, inducing them to resist entering into employment contracts. This resistance to employment contracts vanishes if fairness preferences in combination with reputation opportunities keep principals from abusing their power, leading to the widespread, endogenous formation of efficient long-run employment relations. Our results inform the theory of the firm by showing how behavioral forces shape an important transaction cost of integration – the abuse of authority – and by providing an empirical basis for assessing differences between the Marxian and the Coasian view of the firm, as well as Alchian and Demsetz’s (1972) critique of the Coasian approach.
    Keywords: Theory of the firm, transaction cost economics, authority, power abuse, employment relation, fairness, reputation
    JEL: C91 D23 D86 M5
    Date: 2012–11
  5. By: Iossa, Elisabetta (DEF, University of Rome Tor Vergata, CEPR, CMPO and EIEF); Rey, Patrick (TSE,IDEI)
    Abstract: We study how career concerns affect the dynamics of incentives in a multi-period contract, when the agent’s productivity can evolve exogenously (random shocks) or improve endogenously through investment. We show that incentives are stronger and performance is higher when the contract approaches its expiry date. Contrary to common wisdom, long-term contracts may strengthen reputational effects whereas short-term contracting may be optimal when investment has persistent, long-term effects.
    Keywords: Career concerns, contract duration,contract renewal, reputation and dynamic incentives.
    Date: 2012–11
  6. By: Andrea Attar (Department of Economics, Law and Institutions, University of Rome "Tor Vergata"); Catherine Casamatta (Toulouse School of Economics); Arnold Chassagnon (Université de Tours and Paris School of Economics); Jean Paul Décamps (Toulouse School of Economics)
    Abstract: This paper investigates how the use of covenants in financial contracts affects competition in capital markets subject to moral hazard. Financial contracts offered by investors are non-exclusive, i.e. entrepreneurs can trade with several investors at a time. To restrict entrepreneurs’ ability to trade with competitors, investors can include in their contracts ex post punishments contingent on the firm’s outside investment or indebtedness, which we interpret as covenants. When covenants are precluded, the equilibrium outcome is always efficient, and unique when the moral hazard problem is severe. Then, the aggregate of lenders earn monopoly profits. If covenants can be included in financial contracts, every incentive compatible individually rational allocation can be supported at equilibrium: market equilibria are indeterminate and Pareto-ranked. Contrary to common wisdom, covenants alone do not enhance competition. We then investigate the impact of two institutional mechanisms (information sharing systems and loan subsidies) to mitigate entrepreneurs’ incentive to trade excessively. Both mechanisms restore efficiency, but only loan subsidies can sustain the competitive outcome as the unique equilibrium allocation.
    Keywords: Non-Exclusivity, Credit Rationing, Debt Covenants.
    JEL: D43 D82 G33
    Date: 2013–01–18
  7. By: Maarten Janssen (University of Vienna); Vladimir Karamychev (Erasmus University Rotterdam)
    Abstract: We analyze the effects of mergers in first-price sealed-bid auctions on bidders' equilibrium bidding functions and on revenue. We also study the incentives of bidders to merge given the private information they have. We develop two models, depending on how after-merger valuations are created. In the first, single-aspect model, the valuation of the merged firm is the maximum of the valuations of the two firms engaged in the merger. In the multi-aspect model, a bidder's valuation is the sum of two components and a merged firm chooses the maximum of each component of the two merging firms. In the first model, a merger creates incentives for bidders to shade their bids leading to lower revenue. In the second model, the non-merging firms do not shade their bids and revenue is actually higher. In both models, we show that all bidders have an incentive to merge.
    Keywords: Mergers; first-price sealed-bid auctions
    JEL: D44 D82
    Date: 2013–01–10
  8. By: Ernst Fehr; Holger Herz; Tom Wilkening
    Abstract: Authority and power permeate political, social, and economic life, but empirical knowledge about the motivational origins and consequences of authority is limited. We study the motivation and incentive effects of authority experimentally in an authority- delegation game. Individuals often retain authority even when its delegation is in their material interest - suggesting that authority has non-pecuniary consequences for utility. Authority also leads to over-provision of effort by the controlling parties, while a large percentage of subordinates under-provide effort despite pecuniary incentives to the contrary. Authority thus has important motivational consequences that exacerbate the inefficiencies arising from suboptimal delegation choices.
    Keywords: Organizational behavior, incentives, experiments and contracts
    JEL: C92 D83 D23
    Date: 2012–11
  9. By: Gürtler, Marc; Gürtler, Oliver
    Abstract: We investigate the effect of employee heterogeneity on the incentive to put forth effort in a market-based tournament. Employers use the tournament's outcome to estimate employees' abilities and accordingly condition their wage offers. Employees put forth effort, because by doing so they increase the probability of outperforming the rival, thereby increasing their ability assessment and thus the wage offer. We demonstrate that the tournament outcome provides more information about employees' abilities in case they are heterogeneous. Thus, employees get a higher incentive to affect the tournament outcome, and employers find it optimal to hire heterogeneous contestants. --
    Keywords: tournament,competitive labor market,heterogeneity,learning
    JEL: D83 J24 J31 M51
    Date: 2013
  10. By: Afrasiab Mirza
    Abstract: This paper investigates regulations for banks that covered by deposit insurance in a dynamic setting where bankruptcy entails social costs. Regulatory policy operates through rules governing the bank's capital structure and asset allocation that may be adjusted each period. Throughout, the regulator must take into account that the bank is better informed about the inherent risks of its assets (adverse selection) and may forgo unobservable and costly actions to improve asset quality (moral hazard). Under the optimal regulatory policy under banks face risk-adjusted capital requirements but also hard-caps on size and leverage. In addition, the optimal policy counteracts pro-cyclical bank behaviour through the use of capital buffers.
    Keywords: Capital Regulation, Deposit Insurance, Risk-shifting
    JEL: G2 G3 G21 G28 G32
    Date: 2012–12
  11. By: Andrew Beauchamp (Boston College); Mathis Wagner (Boston College)
    Abstract: Despite facing some of the same challenges as private insurance markets, little is known about the role of adverse selection in social insurance programs. This paper studies adverse selection in Social Security retirement choices using data from the Health and Retirement Study. We find robust evidence that people who live longer choose larger annuities by delaying the age they first claim benefits, a form of adverse selection. To quantify welfare consequences we develop and estimate a simple model of annuity choice. We exploit variation in longevity, the underlying source of private information, to identify the key structural parameters: the coefficient of relative risk aversion and the discount rate. We estimate that adverse selection reduces social welfare by 2.3-3.5 percent, and increases the costs to the Social Security Trust Fund by 2.1-2.5 percent, relative to the first best allocation. Counterfactual simulations suggest program adjustments could generate both economically significant decreases in costs and small increases in social welfare. We estimate an optimal non-linear accrual rate which would result in welfare gains of 1.4 percent, and cost reductions of 6.1 percent of current program costs.
    Keywords: Adverse Selection, Social Security, Optimal Policy
    JEL: J26 D82
    Date: 2012–12–31
  12. By: Fulbert, Tchana Tchana; Georges, Tsafack
    Abstract: The ability of a portfolio manager to deliver higher returns with relatively low risk is a fundamental issue in finance. We analyze here the performance of a portfolio manager under two different types of constraints. For a manager with private information, we compare the effect of value at risk (VaR) and short-selling constraints on the relation between the expected portfolio return and the market return. We find that in more volatile market, the VaR restriction will have a stronger effect on the manager performance compared to the short-selling restriction effect. The VaR constraint also strongly affects a manager with good quality of information while the short-selling restriction moderately affects manager with any level of information quality. For the manager attitude toward the risk, a too aggressive manager will find his overall performance more affected by the VaR constraint. Therefore, financial institutions such as large investment banks and hedge-funds with a strong ability to obtain superior information could be more affected by a very strong VaR restriction than by a short-selling restriction.
    Keywords: Performance valuation; Asymmetric information; Financial regulation; VaR restriction; Short-Selling restriction
    JEL: G11 G28 G32
    Date: 2013–05–17
  13. By: Emilio Espino; Julian Kozlowski; Juan M. Sánchez
    Abstract: This paper studies the efficient arrangement among several agents that are subject to idiosyncratic, privately observed taste shocks affecting their marginal utility of current consumption. Agents accumulate capital and have access to a technology to produce goods. The framework deviates from previous literature, which assumed that (i) there is a continuum of agents and (ii) agents are exogenously endowed with output every period with no investment opportunities. A new method is proposed to solve for the optimal allocation that takes advantage of the fact that the utility possibility set is convex. Pareto weights play the role of promised utility in Abreu, Pearce, and Stac- chetti (1990). The method is applied to study efficiency in a partnership between the founder, who faces the taste shock, and the partner, who provides funds but do not face shocks. New insights are derived. Under private information the ownership structure determines to what extent private information matters. If the founder’s share of the partnership is too big his incentives to cheat vanish. Additionally, efficiency implies that, while incentive constraints bind, equity shares must fluctuate to alleviate infor- mation problems. In the long run, there are two possible extreme structures: (1) the founder’s equity share becomes sufficiently large to make the incentive problem irrele- vant and (2) the founder’s equity share converges to zero. Two alternative economies are studied to understand the role of key assumptions: (i) an endowment economy and (ii) an economy in which both partners face taste shocks. It turned out that to obtain the main results allowing for a production economy is crucial but having only one agent with shock is not.>
    Keywords: Disclosure of information ; Risk ; Capital
    Date: 2013
  14. By: Stephane Verani; Till Gross
    Abstract: There is growing empirical support for the conjecture that access to credit is an important determinant of firms' export decisions. We study a multi-country general equilibrium economy in which entrepreneurs and lenders engage in long-term credit relationships. Financial constraints arise as a consequence of financial contracts that are optimal under private information. Consistent with empirical regularities, the model implies that older and larger firms have lower average and more stable growth rates, and are more likely to survive. Exporters are larger, their survival in international markets increases with the time spent exporting, and the sales of older exporters are larger and more stable.
    Date: 2013
  15. By: Jeffrey V. Butler; Enrica Carbone; Pierluigi Conzo; Giancarlo Spagnolo
    Abstract: This paper reports results from a laboratory experiment exploring the relationship between reputation and entry in procurement. We propose a procurement model with reputation and entry assigning to the entrant a reputational advantage of varying size across treatments. There is widespread concern among regulators that favoring suppliers with good past performance, a standard practice in private procurement, may hinder entry by new (smaller or foreign) firms in public procurement markets. Our results suggest that while some reputational mechanisms indeed reduce the frequency of entry, appropriately designed reputation mechanisms actually stimulate it. Since quality increases but not prices, our data also suggest that the introduction of reputation may generate large welfare gains for the buyer.
    Keywords: Entry, Feedback mechanisms, Governance, Incomplete contracts, Limited enforcement, Incumbency, Multidimensional competition, Participation, Past performance, Procurement, Quality, Reputation, Vendor rating.
    JEL: H57 L14 L15
    Date: 2012–12

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