nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒04‒13
23 papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Irrelevance of private information in two-period economies with more goods than states of nature By Joao Correia-da-Silva; Carlos Hervés-Beloso
  2. Common-Value All-Pay Auctions with Asymmetric Information By Einy, Ezra; Haimanko, Ori; Orzach, Ram; Sela, Aner
  3. Gaming and Strategic Ambiguity in Incentive Provision By Ederer, Florian; Holden, Richard; Meyer, Margaret A
  4. Search and Work in Optimal Welfare Programs By Pavoni, Nicola; Setty, Ofer; Violante, Giovanni L
  5. "An Econometric Analysis of Insurance Markets with Separate Identification for Moral Hazard and Selection" By Shinya Sugawara; Yasuhiro Omori
  6. Contracting under Incomplete Information and Social Preferences: An Experimental Study By Hoppe, Eva I; Schmitz, Patrick W
  7. Multidimensional screening with complementary activities: regulating a monopolist with unknown cost and unknown preference for empire-building By Ana P. Borges; Didier Laussel; João Correia-da-Silva
  8. Strategic Framing in Contracts By Katharina Hilken; Kris De Jaegher; Marc Jegers
  9. Crowd-sourcing with uncertain quality - an auction approach By Papakonstantinou, A.; Bogetoft, P.
  10. Banker compensation and bank risk taking: the organizational economics view By Arantxa Jarque; Edward S. Prescott
  11. Trading and information diffusion in OTC markets By Babus, Ana; Kondor, Péter
  12. Information Environment and The Cost of Capital By Orie Barron; Xuguang Sheng; Maya Thevenot
  13. Bargaining position, bargaining power, and the property rights approach By Schmitz, Patrick W
  14. Equilibrium Collateral Constraints By Cecilia Parlatore Siritto
  15. All-Pay Auctions: Implementation and Optimality By Jönsson, Stefan; Schmutzler, Armin
  16. Investments in physical capital, relationship-specificity, and the property rights approach By Schmitz, Patrick W
  17. Lemons & Loons By Timothy Perri
  18. The More Abstract the Better? Raising Education Cost for the Less Able when Education is a Signal By Timothy Perri
  19. Asymmetric information and the death of ABS CDOs By Daniel O. Beltran; Larry Cordell; Charles P. Thomas
  20. Antitrust as facilitating factor for collusion By Vermeulen A.J.; Bos A.M.; Letterie W.A.
  21. Motivating Knowledge Agents: Can Incentive Pay Overcome Social Distance? By Erlend Berg; Maitreesh Ghatak; R Manjula; D Rajasekhar; Sanchari Roy
  22. Bonus Culture: Competitive Pay, Screening, and Multitasking By Bénabou, Roland; Tirole, Jean
  23. Discount Pricing By Armstrong, Mark; Chen, Yongmin

  1. By: Joao Correia-da-Silva (CEFUP e Faculdade de Economia, Universidade do Porto); Carlos Hervés-Beloso (RGEA, Facultad de Económicas, Universidad de Vigo)
    Abstract: We introduce a two-period economy with asymmetric information about the state of nature that occurs in the second period. Each agent is endowed with an information structure that describes her (incomplete) ability to prove whether or not a state has occurred. We show that if the number of states of nature is not greater than the number of goods, then, generically, the equilibria of the associated full information economy are also equilibria of the asymmetric information economy. The information structures of the agents are, in that sense, irrelevant.
    Keywords: General equilibrium, Asymmetric information, Private state-verification,Two-period economies, Generic existence of equilibrium, Generic efficiency
    JEL: C62 C72 D51 D82
    Date: 2012–12
  2. By: Einy, Ezra; Haimanko, Ori; Orzach, Ram; Sela, Aner
    Abstract: We study two-player common-value all-pay auctions (contests) with asymmetric information under the assumption that one of the players has an information advantage over his opponent. We characterize the unique equilibrium in these contests, and examine the role of information in determining the players' expected efforts, probabilities of winning, and expected payoffs. In particular, we show that the players always have the same probability of winning the contest, and that their expected efforts are the same, but their expected payoffs are different. It is also shown that budget constraints may have an unanticipated effect on the players' expected payoffs, i.e., a player's information advantage may turn into a payoff disadvantage.
    Keywords: all-pay auctions; asymmetric information; information advantage
    JEL: C72 D44 D82
    Date: 2013–01
  3. By: Ederer, Florian; Holden, Richard; Meyer, Margaret A
    Abstract: It is often suggested that incentive schemes under moral hazard can be gamed by an agent with superior knowledge of the environment, and that deliberate lack of transparency about the incentive scheme can reduce gaming. We formally investigate these arguments. Ambiguous incentive schemes induce more balanced efforts from an agent who performs multiple tasks and is better informed about the environment, but also impose more risk on the agent. If tasks are sufficiently complementary for the principal, ambiguous schemes can dominate the best deterministic scheme and can completely eliminate the efficiency losses from the agent's better knowledge of the environment.
    Keywords: ambiguity; contracts; gaming; incentives; randomization
    JEL: L13 L22
    Date: 2013–01
  4. By: Pavoni, Nicola; Setty, Ofer; Violante, Giovanni L
    Abstract: Some existing welfare programs (“work-first”) require participants to work in exchange for benefits. Others (“job search-first”) emphasize private job-search and provide assistance in finding and retaining a durable employment. This paper studies the optimal design of welfare programs when (i) the principal/government is unable to observe the agent’s effort, but can assist the agent’s job search and can mandate the agent to work, and (ii) agents’ skills depreciate during unemployment. In the optimal welfare program, assisted search is implemented between an initial spell of private search (unemployment insurance) and a final spell of pure income support where search effort is not elicited. To be effective, job-search assistance requires large reemployment subsidies. The optimal program features compulsory work activities for low levels of program’s generosity (i.e., its promised utility or available budget). The threat of mandatory work acts like a punishment that facilitates the provision of search incentives without compromising consumption smoothing too much.
    Keywords: Moral Hazard; Recursive Contracts; Search; Welfare Program; Work
    JEL: D82 H21 J24 J64 J65
    Date: 2013–03
  5. By: Shinya Sugawara (Japan Society of Promotion of Science and Graduate School of Economics, University of Tokyo); Yasuhiro Omori (Faculty of Economics, University of Tokyo)
    Abstract: This paper proposes a simple microeconometric framework that can separately identify moral hazard and selection problems in insurance markets. Our econometric model is equivalent to the approach that is utilized for entry game analyses. We employ a Bayesian estimation approach that avoids a partial identification problem. Due to the standard identification, we propose a statistical model selection method to detect an information structure that consumers face. Our method is applied to the dental insurance market in the United States. In this market, we find not only standard moral hazard but also advantageous selection, which has an intuitive interpretation in the context of dental insurance.
    Date: 2013–03
  6. By: Hoppe, Eva I; Schmitz, Patrick W
    Abstract: Principal-agent models in which the agent has access to private information before a contract is signed are a cornerstone of contract theory. We have conducted an experiment with 720 participants to explore whether the theoretical insights are reflected by the behavior of subjects in the laboratory and to what extent deviations from standard theory can be explained by social preferences. Investigating settings with both exogenous and endogenous information structures, we find that agency theory is indeed useful to qualitatively predict how variations in the degree of uncertainty affect subjects' behavior. Regarding the quantitative deviations from standard predictions, our analysis based on several control treatments and quantal response estimations shows that agents' behavior can be explained by social preferences that are less pronounced than in conventional ultimatum games. Principals' own social preferences are not an important determinant of their behavior. However, when the principals make contract offers, they anticipate that social preferences affect agents' behavior.
    Keywords: Adverse selection; Agency theory; Experiment; Information gathering; Social preferences; Ultimatum game
    JEL: C72 C91 D82 D86
    Date: 2013–01
  7. By: Ana P. Borges (NIDISAG - Núcleo de Investigação do Instituto Superior de Administração e Gestão); Didier Laussel (Aix-Marseille Université (AMSE)); João Correia-da-Silva (CEF.UP e Faculdade de Economia, Universidade do Porto)
    Abstract: We study optimal regulation of a monopolist when intrinsic efficiency (intrinsic cost) and empire-building tendency (marginal utility of output) are private information but actual cost (difference between intrinsic cost and effort level) is observable. This is a problem of multidimensional screening with complementary activities. Results are mainly driven by two elements: the correlations between types; and the relative magnitude of the uncertainty along the two dimensions of private information. If the marginal utility of output varies much more (resp. less) across managers than the intrinsic marginal cost, then we have empire-building (resp. efficiency) dominance. In that case, an inefficient empire-builder produces more (resp. less) and at lower (resp. higher) marginal cost than an efficient money-seeker. It is only when variabilities are similar that we obtain the natural ranking of activities (empire-builders produce more while efficient managers produce at a lower cost).
    Keywords: Multidimensional screening, regulation, procurement, empire-building, adverse selection.
    JEL: D82 H42 L51
    Date: 2013–02
  8. By: Katharina Hilken; Kris De Jaegher; Marc Jegers
    Abstract: We provide a hidden-action principal-agent model where the agent has reference- dependent preferences. The loss-averse agent considers the base wage as reference point, and bonuses and/or penalties as gains and losses, respectively. When choosing optimal payments, the principal strategically sets the base wage, knowing that this determines the agent's reference point. We consider two variants of the model. In a first variant, the agent's reservation utility is not reference-dependent. We show that it is always optimal in this case for the principal to employ bonuses. In a second variant, the reservation utility is reference-dependent and the principal may use penalties.
    Keywords: Strategic Framing; Reference-Dependent Preferences; Principal-Agent Theory; Optimal Payment Schemes; Employment Contracts
    JEL: D86 D03 J33 M52
    Date: 2013–03
  9. By: Papakonstantinou, A.; Bogetoft, P.
    Abstract: This article addresses two important issues in crowd-sourcing: ex ante uncertainty about the quality and cost of different workers and strategic behaviour. We present a novel multi-dimensional auction that incentivises the workers to make partial enquiry into the task and to honestly report quality-cost estimates based on which the crowd-sourcer can choose the worker that offers the best value for money. The mechanism extends second score auction design to settings where the quality is uncertain and it provides incentives to both collect information and deliver desired qualities.
    Keywords: crowd-sourcing; Multi-dimensional auctions; Yardstick competition; Score functions; Strictly proper scoring rules;
    JEL: D86 D84 D81 D82
    Date: 2013–02–06
  10. By: Arantxa Jarque; Edward S. Prescott
    Abstract: Models of banks operating under limited liability with deposit insurance and employee incentive problems are used to analyze how banker compensation contracts can contribute to bank risk shifting. The first model is a multi-agent, moral-hazard model, where each agent (e.g. a loan officer) operates a risky lending technology. Results differ from the single-agent model; pay for performance contracts do not necessarily indicate risk at the bank level. Correlation of returns is the most important factor. If loan officer returns are uncorrelated, the form of pay is irrelevant for risk. If returns are correlated, a low wage causes risk. If correlation is endogenous, relative performance contracts that encourage correlation of returns can create bank risk. A sufficient condition for a contract to induce risk at the bank level is provided. The second model adds a loan review and risk management function that affects risk characteristics of loan officers' loans. Counter to common perception, paying loan reviewers and risk managers for performance does not necessarily create risk. The model also identifies the importance of evaluating the quality of bank controls as a means for limiting bank risk.
    Keywords: Bank supervision
    Date: 2013
  11. By: Babus, Ana; Kondor, Péter
    Abstract: We model trading and information diffusion in OTC markets, when dealers can engage in many bilateral transactions at the same time. We show that information diffusion is effective, but not efficient. While each bilateral price partially reveals all dealers' private information after a single round of trading, dealers could learn more even within the constraints imposed by our environment. This is not a result of dealers' market power, but arises from the interaction between decentralization and differences in dealers' valuation of the asset. We apply our framework to confront several explanations for the disruption of OTC markets with stylized facts from the empirical literature. We find more support for narratives emphasizing increased counterparty risk as opposed to increased informational frictions.
    Keywords: bilateral trading; demand schedule equilibrium; information aggregation; networks; over-the-counter markets
    JEL: D82 D85 G14
    Date: 2013–01
  12. By: Orie Barron (The Pennsylvania State University); Xuguang Sheng (American University); Maya Thevenot (Florida Atlantic University)
    Abstract: In empirical tests guided by recent theory (e.g., Hughes, Liu and Liu 2007; and Lambert, Leuz and Verrecchia 2012), we examine the joint effects of information asymmetry and information precision on the cost of capital and how these effects vary based on the amount and quality of available information and the level of market competition. Consistent with theory, we find that average information precision is an important factor that may alter the relation between information asymmetry and the cost of capital, leading to erroneous inferences, if not considered. We also show that, while information asymmetry increases the cost of capital in most settings, it decreases the cost of capital when the amount of public information is low, while it has no effect when the total information is of high quality and when there is a high level of market competition. Our final results indicate that the precision of private information decreases the cost of capital when the amount of public information is low, while it increases it when the quality of total information is low. Besides examining various aspects of the environment jointly, our study is also unique in that we use better measures of information asymmetry and precision, which allows us to tease out the economic significance of each factor on cost of capital. We find that cost of equity capital varies greatly with our measures of information asymmetry and average information precision. For example, our regression estimates suggest that information asymmetry and average information precision are comparable in importance to equity beta and firm size in determining firms’ cost of capital.
    Keywords: cost of capital, information quality, information asymmetry, ST uncertainty, BKLS
    JEL: M41 G14 G12 D82
    Date: 2013–04
  13. By: Schmitz, Patrick W
    Abstract: In the property rights approach to the theory of the firm (Hart, 1995), parties bargain about whether or not to collaborate after non-contractible investments have been made. Most contributions apply the regular Nash bargaining solution. We explore the implications of using the generalized Nash bargaining solution. A prominent finding regarding the suboptimality of joint ownership turns out to be robust. However, in contrast to the standard property rights model, it may well be optimal to give ownership to a party whose investments are less productive, provided that this party's ex-post bargaining power is relatively small.
    Keywords: bargaining; incomplete contracts; investment incentives; ownership
    JEL: C78 D23 D86 L23
    Date: 2013–01
  14. By: Cecilia Parlatore Siritto (NYU)
    Abstract: I study a model in which banks need to borrow to make risky loans whose return is private information known only by the bank who made the loan. To raise funds, banks can either sell assets or pledge them as collateral. I show that collateral contracts arise in equilibrium even though all agents would value the asset the same in autarky. The persistence in the role as borrowers or lenders and the banks' ability to make a profits from loans imply that banks will value the asset more than lenders. On top of paying dividends, the asset resolves the banks' maturity mismatch problem and, since it is used as collateral, it relaxes a borrowing constraint. The amount that can be borrowed against the asset is determined in equilibrium. I show that increases in risk may decrease the asset's debt capacity and, thus, the level of intermediation in the economy.
    Date: 2012
  15. By: Jönsson, Stefan; Schmutzler, Armin
    Abstract: This paper analyzes how all-pay auctions with endogenous prizes can be used to provide effort incentives. We show that wide classes of effort distributions can be implemented as equilibrium outcomes of such games. We also ask how all-pay auctions have to be structured so as to induce high expected highest efforts without generating excessive wasteful efforts of losers. All-pay auctions with endogenous prizes can do better than all-pay auctions with fixed prizes in this respect, in particular, when the prize function is approximately linear. We use the results to compare patents and prizes as innovation incentives, and to explore promotion incentives in organizations.
    Keywords: all-pay auctions; contests; endogenous prizes; implementation
    JEL: D02 D43 D44
    Date: 2013–01
  16. By: Schmitz, Patrick W
    Abstract: We reconsider the property rights approach to the theory of the firm based on incomplete contracts. We explore the implications of different degrees of relationship-specificity when there are two parties, A and B, who can make investments in physical capital (instead of human capital). If relationship-specificity is exogenously given, it turns out that joint asset ownership can be optimal only if the degree of relationship-specificity is sufficiently small. If relationship-specificity can be freely chosen and if party A's investments are more productive, then the parties deliberately choose a strictly positive level of relationship-specificity and they always agree on sole ownership by party A.
    Keywords: incomplete contracts; investment incentives; ownership; relationship-specificity; theory of the firm
    JEL: C78 D23 D86 L22 L24
    Date: 2013–03
  17. By: Timothy Perri
    Abstract: Akerlof (2012, 2013) has argued individuals often do not behave according to rational expectations. He shows how buyers in a complete lemon’s market are worse off if they behave irrationally---like loons. We examine several different lemon’s market situations (including when workers may signal or be screened to reveal their quality) to determine the effects on welfare for loons and for society as a whole. Sometimes there are opposite effects for welfare for society and loons. Also, in some cases, both society and loons are better off due to loony behavior. Key Words: Lemons, asymmetric information, and signaling
    JEL: D82
    Date: 2013
  18. By: Timothy Perri
    Abstract: More able individuals may over-investment in education when education signals ability. If education directly increases productivity, increasing education cost for the less able may increase welfare by reducing over-investment by the more able, but will not do so if such cost is already either too small or too large because no over-investment then occurs. Increasing cost for the less able is most likely to increase welfare when education is relatively unproductive compared to the initial ability difference between more and less able individuals. Our results have implications for online education which may lower cost relatively more for the less able. Key Words: Signaling, pooling, and education cost
    JEL: D82
    Date: 2013
  19. By: Daniel O. Beltran; Larry Cordell; Charles P. Thomas
    Abstract: A key feature of the 2007 financial crisis is that for some classes of securities trade has practically ceased. And where trade has occurred, it appears that market prices are well below their intrinsic values. This seems especially true for those securities where the payoff streams are particularly complex, for example, structured finance ABS CDOs. One explanation for this is that information about these securities' intrinsic values since the crisis has been asymmetric, with current holders having better information than potential buyers. We first characterize the information asymmetries that were present in the structured finance ABS CDO market. Because many of the CDO dealers had partially or fully integrated the pipeline from mortgage originations through CDO issuance, they had informational advantages over potential buyers that could well have disrupted trading in CDOs as the crisis took hold in August of 2007. Using a "workhorse" model for pricing securities under asymmetric information and a novel dataset for the intrinsic values of ABS CDOs, we show how the resulting adverse selection problem could explain why the bulk of these securities either trade at significant discounts to their intrinsic values or do not trade at all.
    Date: 2013
  20. By: Vermeulen A.J.; Bos A.M.; Letterie W.A. (GSBE)
    Abstract: We study collusion in an infinitely repeated prisoners' dilemma when firms' discount factor is private information. If tacit collusion is not feasible, firms that are capable of sustaining high prices may still be willing and able to collude explicitly. Firms eager to collude may signal their intentions when forming the agreement is costly, but not too costly. As antitrust makes explicit collusion costly in expected terms, it may in fact function as a signaling device. We show that there always exists a cost level for which explicit collusion is viable. Moreover, our analysis suggests that antitrust enforcement is unable to fully deter collusion.
    Keywords: Market Structure, Firm Strategy, and Market Performance: General;
    Date: 2013
  21. By: Erlend Berg; Maitreesh Ghatak; R Manjula; D Rajasekhar; Sanchari Roy
    Abstract: This paper studies the interaction of incentive pay and social distance in the dissemination of information. We analyse theoretically as well as empirically the effect of incentive pay when agents have pro-social objectives, but also preferences over dealing with one social group relative to another. In a randomised field experiment undertaken across 151 villages in South India, local agents were hired to spread information about a public health insurance programme. Relative to at pay, incentive pay improves knowledge transmission to households that are socially distant from the agent, but not to households similar to the agent.
    Keywords: public services, information constraints, incentive pay, social proximity, knowledge transmission
    JEL: C93 D83 I38 M52 O15 Z13
    Date: 2013–03
  22. By: Bénabou, Roland; Tirole, Jean
    Abstract: This paper analyzes the impact of labor market competition and skill-biased technical change on the structure of compensation. The model combines multitasking and screening, embedded into a Hotelling-like framework. Competition for the most talented workers leads to an escalating reliance on performance pay and other high-powered incentives, thereby shifting effort away from less easily contractible tasks such as long-term investments, risk management and within-firm cooperation. Under perfect competition, the resulting efficiency loss can be larger than that imposed by a single firm or principal, who distorts incentives downward in order to extract rents. More generally, as declining market frictions lead employers to compete more aggressively, the monopsonistic underincentivization of low-skill agents first decreases, then gives way to a growing overincentivization of high-skill ones. Aggregate welfare is thus hill-shaped with respect to the competitiveness of the labor market, while inequality tends to rise monotonically. Bonus caps and income taxes can help restore balance in agents' incentives and behavior, but may generate their own set of distortions.
    Keywords: adverse selection; bonuses; competition; contracts; executive compensation; Hotelling; incentives; inequality; moral hazard; performance pay; screening; work ethic
    JEL: D31 D82 D86 J31 J33 L13 M12
    Date: 2013–04
  23. By: Armstrong, Mark; Chen, Yongmin
    Abstract: We investigate the marketing practice of framing a price as a discount from an earlier price. We discuss two reasons why a discounted price---rather than a merely low price---can make a consumer more willing to purchase. First, a high initial price can indicate the product is high quality. Second, a high initial price can signal a bargain relative to other options, and there is less incentive to search. We also discuss a behavioral model where the propensity to buy increases when others pay more. A seller has an incentive to offer false discounts, where the initial price is exaggerated.
    Keywords: consumer protection; consumer search; false advertising; price discrimination; Reference dependence
    JEL: D03 D18 D83 M3
    Date: 2013–02

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