nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒05‒19
23 papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Sharing Information through Delegation and Collaboration By Otto H. Swank; Bauke Visser
  2. Imperfect Evaluation in Project Screening By Andrei Barbos
  3. Mergers in Bidding Markets By Maarten Janssen; Vladimir Karamychev
  4. Social Relations and Relational Incentives By Robert Dur; Jan Tichem
  5. Altruism and Relational Incentives in the Workplace By Dur, Robert; Tichem, Jan
  6. The Impact of Resale on Entry in Second Price Auctions By Che, XiaoGang; Lee, Peter; Yang, Yibai
  7. Do More Powerful Interest Groups have a Disproportionate Influence on Policy? By Zara Sharif; Otto H. Swank
  8. Banking Competition and Soft Budget Constraints: How Market Power can threaten Discipline in Lending By Stefan Arping
  9. On the Stability of Equilibria in Incomplete Information Games under Ambiguity By Giuseppe De Marco; Maria Romaniello
  10. Intention-Based Reciprocity and the Hidden Costs of Control By Ferdinand von Siemens
  11. Severity vs. Leniency Bias in Performance Appraisal: Experimental evidence By Lucia Marchegiani; Tommaso Reggiani; Matteo Rizzolli
  12. Bailouts, time inconsistency, and optimal regulation By V.V. Chari; Patrick J. Kehoe
  13. Shotguns and Deadlocks By Landeo, Claudia; Spier, Kathryn
  14. Facing Your Opponents: Social Identification and Information Feedback in Contests By Mago , Shakun; Samak , Anya; Sheremeta, Roman
  15. On the non-optimality of a Diamond-Dybvig contract in the Goldstein-Pauzner environment By Mahmoud Elamin
  16. Information Acquisition and Innovation under Competitive Pressure By Andrei Barbos
  17. Information at a Cost: A Lab Experiment By Pedro Robalo; Rei S. Sayag
  18. Local politics and economic geography By Berliant, Marcus; Tabuchi, Takatoshi
  19. What drives fraud in a credence goods market? Evidence from a field study By Alexander Rasch; Christian Waibel
  20. Credit Protection and Lending Relationships By Stefan Arping
  21. Strategic versus Financial Investors: The Role of Strategic Objectives in Financial Contracting By Stefan Arping; Sonia Falconieri
  22. What to put on and what to keep off the Table? A Politician's Choice of which Issues to address By Rei S. Sayag; Otto H. Swank
  23. The Role of Performance Appraisals in Motivating Employees By Jurjen J.A. Kamphorst; Otto H. Swank

  1. By: Otto H. Swank (Faculty of Economics, Erasmus Universiteit Rotterdam); Bauke Visser (Faculty of Economics, Erasmus Universiteit Rotterdam)
    Abstract: This article analyzes under which conditions a manager can motivate a junior worker by verbal communication, and explains why communication is often tied up with organizational choices as job enlargement and collaboration. Our model has two important features. First, the manager has more information about a junior's ability than the junior himself. Second, the junior's effort and ability are complements. We show that the manager has an incentive to exaggerate the junior's ability. We discuss two ways in which the manager can make credible statements about the junior's ability. First, the senior can delegate a task to the junior for which it is important that the junior has a correct perception of his ability. Information is shared through a costless signal. Second, the senior can spend more time on a junior she perceives as able than on a junior she perceives as less able. Information is then shared through a costly signal.
    Keywords: Communication; incentives; signalling; overconfidence; delegation; collaboration
    JEL: C70 D23 D83
  2. By: Andrei Barbos (Department of Economics, University of South Florida)
    Abstract: This paper studies a model in which an agent considers proposing a project of unknown quality to an evaluator, who has to decide on whether or not to accept it. Earlier papers considered the case when the evaluation is perfect and showed than higher submission fees increase the expected quality of projects submitted for review by discouraging long-shot submissions. We examine the case of two-sided incomplete information where not only the agent's, but also the evaluator's assessment of the project is imperfect. We show that under this specifcation, an increase in the submis- sion fee may lead to a decrease in the quality of projects that are implemented because of its adverse effects on the evaluator's acceptance policy.
    Keywords: Evaluation, Project Screening, Regulatory Burden
    JEL: D02 D82 L50
    Date: 2013–01
  3. 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
  4. By: Robert Dur (Erasmus University Rotterdam, CESifo, and IZA); Jan Tichem (Erasmus University Rotterdam)
    Abstract: This paper studies how social relationships between managers and employees affect relational incentive contracts. To this end we develop a simple dynamic principal-agent model where both players may have feelings of altruism or spite toward each other. The contract may contain two types of incentives for the agent to work hard: a bonus and a threat of dismissal. We find that good social relationships undermine the credibility of a threat of dismissal but strengthen the credibility of a bonus. Among others, these two mechanisms imply that better social relationships sometimes lead to higher bonuses, while worse social relationships may increase productivity and players' utility in equilibrium.
    Keywords: Altruism, spite, social relations, incentives, relational contracts, efficiency wages, subjective performance evaluation, Nash bargaining
    JEL: D23 J33 M52 M55
    Date: 2012–05–16
  5. By: Dur, Robert (Erasmus University Rotterdam); Tichem, Jan (Erasmus University Rotterdam)
    Abstract: This paper studies how altruism between managers and employees affects relational incentive contracts. To this end we develop a simple dynamic principal-agent model where both players may have feelings of altruism or spite toward each other. The con- tract may contain two types of incentives for the agent to work hard: a bonus and a threat of dismissal. We find that altruism undermines the credibility of a threat of dis- missal but strengthens the credibility of a bonus. Among others, these two mechanisms imply that higher altruism sometimes leads to higher bonuses, while lower altruism may increase productivity and players utility in equilibrium.
    Keywords: altruism, spite, incentives, relational contracts, efficiency wages, subjective performance evaluation, Nash bargaining
    JEL: D23 J33 M52 M55
    Date: 2013–04
  6. By: Che, XiaoGang (University of Alberta, Department of Economics); Lee, Peter (University of Sydney); Yang, Yibai (University of Nottingham Ningbo China)
    Abstract: This paper investigates the effect of resale allowance on entry strategies in a second price auction with two bidders whose entries are sequential and costly. We first characterize the perfect Bayesian equilibrium in cutoff strategies. We then show that there exists a unique threshold such that if the reseller's bargaining power is greater (less) than the threshold, resale allowance causes the leading bidder (the following bidder) to have a higher (lower) incentive on entry; i.e., the cutoff of entry becomes lower (higher). We also discuss asymmetric bidders and the original seller's expected revenue.
    Keywords: second price auctions; costly participation; sequential entry; resale
    JEL: D44
    Date: 2013–05–01
  7. By: Zara Sharif (Erasmus University Rotterdam); Otto H. Swank (Erasmus University Rotterdam)
    Abstract: Decisions-makers often rely on information supplied by interested parties. In practice, some parties have easier access to information than other parties. In this light, we examine whether more powerful parties have a disproportionate influence on decisions. We show that more powerful parties influence decisions with higher probability. However, in expected terms, decisions do not depend on the relative strength of interested parties. When parties have not provided information, decisions are biased towards the less powerful parties. Finally, we show that compelling parties to supply information destroys incentives to collect information.
    Keywords: information collection, communication, interest groups, decision-making
    JEL: D72 D78 D82 H39
    Date: 2012–12–05
  8. By: Stefan Arping (University of Amsterdam)
    Abstract: In imperfectly competitive credit markets, banks can face a tradeoff between exploiting their market power and enforcing hard budget constraints. As market power rises, banks eventually find it too costly to discipline underperforming borrowers by stopping their projects. Lending relationships become "too cozy", interest rates rise, and loan performance deteriorates.
    Keywords: Banking Competition, Soft Budget Constraint Problem, Moral Hazard
    JEL: G2 G3
    Date: 2012–12–20
  9. By: Giuseppe De Marco (Università di Napoli Parthenope and CSEF); Maria Romaniello (Seconda Università di Napoli)
    Abstract: In this paper, we look at the (Kajii and Ui) mixed equilibrium notion, which has been recognized by previous literature as a natural solution concept for incomplete information games in which players have multiple priors on the space of payoff relevant states. We investigate the problem of stability of mixed equilibria with respect to perturbations on the sets of multiple priors. We find out that the (Painlevé-Kuratowski) convergence of posteriors ensures that stability holds; whereas, convergence of priors is not enough to obtain stability since it does not always implies convergence of posteriors when we consider updating rules (for multiple priors) based on the classical Bayesian approach.
    Keywords: Incomplete information games, multiple priors, equilibrium stability
    Date: 2013–05–13
  10. By: Ferdinand von Siemens (University of Amsterdam)
    Abstract: Empirical research suggests that - rather than improving incentives - exerting control can reduce workers' performance by eroding motivation. The present paper shows that intention-based reciprocity can cause such motivational crowding-out if individuals differ in their propensity for reciprocity and preferences are private information. Not being controlled might then be considered to be kind, because not everybody reciprocates not being controlled with high effort. This argument stands in contrast to existing theoretical wisdom on motivational crowding-out that is primarily based on signaling models.
    Keywords: extrinsic and intrinsic motivation, crowding-out, intention-based reciprocity
    JEL: A13 C70 D63 D82 L20
    Date: 2011–08–09
  11. By: Lucia Marchegiani (Rome 3 University); Tommaso Reggiani (University of Cologne); Matteo Rizzolli (Free University of Bozen)
    Abstract: Performance appraisal can be biased in two main ways: lenient supervisors assign pre- dominantly high evaluations (thus rewarding also undeserving agents who have exerted no effort) while severe supervisors assign predominantly low evaluations (thus failing to reward deserving agents who have exerted effort). The principal-agent model with moral hazard predicts that both biases will be equally detrimental to effort provision. We test this prediction with a laboratory experiment and we show that failing to reward deserving agents is significantly more detrimental than rewarding undeserving agents. This finding is compatible with empirical evidence on real world supervisors being preponderantly biased towards lenient appraisals. We discuss our result in the light of alternative economic the- ories of behavior. Our result brings interesting implications for strategic human resource management and personnel economics and contributes to the debate about incentives and organizational performance.
    Keywords: Agency theory, Performance appraisal, Type I and Type II errors, Leniency bias, Severity bias, Economic experiment
    JEL: C91 M50 J50
    Date: 2013–05
  12. By: V.V. Chari; Patrick J. Kehoe
    Abstract: We develop a model in which, in order to provide managerial incentives, it is optimal to have costly bankruptcy. If benevolent governments can commit to their policies, it is optimal not to interfere with private contracts. Such policies are time inconsistent in the sense that, without commitment, governments have incentives to bail out firms by buying up the debt of distressed firms and renegotiating their contracts with managers. From an ex ante perspective, however, such bailouts are costly because they worsen incentives and thereby reduce welfare. We show that regulation in the form of limits on the debt-to-value ratio of firms mitigates the time-inconsistency problem by eliminating the incentives of governments to undertake bailouts. In terms of the cyclical properties of regulation, we show that regulation should be tightest in ag-gregate states in which resources lost to bankruptcy in the equilibrium without a government are largest.
    Keywords: Regulation
    Date: 2013
  13. By: Landeo, Claudia (University of Alberta, Department of Economics); Spier, Kathryn (Harvard Law School)
    Abstract: Business divorce is an arduous affair. The process of resolving deadlocks is time consuming and expensive, typically requiring the services of lawyers, financial experts and judges. Prolonged resolution processes, cost-inefficient administration of those processes, and inequitable outcomes impose high monetary and non-monetary costs on the parties themselves and on society as a whole. Asset valuation, which is required to complete the transfer of assets in a business divorce, can pose particular problems for closely-held businesses.In contrast to publicly-traded companies with active markets for equity ownership, closely-held companies may be very difficult for outsider investors and appraisers to evaluate. The economic value of closely-held businesses is often intertwined with the human capital of the founders, their relationships with business associates (including key suppliers and customers), and their tacit business knowledge. The true economic value of closely-held businesses may not be fully reflected in the official business documents and financial statements; instead, the best wisdom concerning the value of the business may lie in the minds of the business owners themselves. This article studies business deadlocks and their resolution. We advance a proposal to reform the way that courts resolve business deadlocks and value business assets. Specifically, we argue that Shotgun mechanisms, where one owner names a single buy-sell price and the other owner is compelled to either buy or sell shares at the named price, should play a larger role in the judicial management of business divorce. Since the party proposing the offer may end up either buying or selling shares, the party has an incentive to identify and name a fair price. Thus, accurate asset valuation is achieved without the use of outside appraisers or inefficient public auctions. We also show that our proposal is aligned with current statutory rules and case law. General partnerships and limited liability companies (LLCs), the most commonly chosen legal entities, are the focus of this study. Important lessons and insights for the judicial resolution of business deadlock are derived from our analysis of the private design and implementation of Shotgun provisions. Although Shotgun provisions have the potential for achieving equitable, expedient, and cost-efficient outcomes, these mechanisms pose challenges in private contractual settings, including the risk of opportunistic behaviors by owners who are at an informational or financial advantage. We argue that these risks are less severe in the judicial context than they are in the private context. Since courts have the ability to design the Shotgun procedure ex-post rather than ex-ante, they are in a better position to identify the presence and nature of the asymmetries and to tailor the mechanism accordingly. Although our arguments regarding the benefits of ex-post judicial design of Shotgun mechanisms are logically consistent and supported by current legal cases, actual field data on the use of these mechanisms is not available. To begin to fill this void, we conducted a series of controlled laboratory experiments with human subjects to assess whether the Shotgun mechanism will have the predicted effects. Our experimental design simulated a deadlocked business venture with two owners where only one of the two owners knew the true value of the business assets. Two different treatments were considered. In the first treatment, the better-informed owner was compelled to make buy-sell offer; in the second treatment, the less-informed owner was compelled to make the buy-sell offer. Our experimental findings support our arguments: (1) Inequitable outcomes arose when the less-informed owner made the buysell offer, and (2) equitable outcomes were obtained when the better informed owner made the buy-sell offer. Specifically, when obligated to make a buy-sell offer, the better-informed owner truthfully revealed his private information to the less-informed owner. To the best of our knowledge, ours is the first experimental study of mandatory Shotgun mechanisms where one party knows the value of the assets while the other does not. Our analysis demonstrates that the application of Shotgun mechanisms by judges when they are called upon to resolve deadlocks and manage business divorce will serve the interests of the business parties themselves and, more generally, the interest of society as a whole.
    Keywords: judicial resolution of business deadlocks; general partnerships; liited liabiity companies; closely-held business entities; shotgun provisions; buy-sell clauses; cake-cutting mechanisms; bargaining with common values; asymmetric information; experiments
    JEL: C72 C90 D82 K20 K40
    Date: 2013–05–01
  14. By: Mago , Shakun; Samak , Anya; Sheremeta, Roman
    Abstract: We experimentally investigate the effect of social identification and information feedback on individual behavior in contests. In all treatments we find significant over-expenditure of effort relative to the standard theoretical predictions. Identifying subjects through photo display decreases wasteful effort. Providing information feedback about others’ effort does not affect the aggregate effort, but it decreases the heterogeneity of effort and significantly affects the dynamics of individual behavior. We develop a behavioral model which incorporates a non-monetary utility of winning and relative payoff maximization. The model explains significant over-expenditure of effort. It also suggests that decrease in ‘social distance’ between group members through photo display promotes pro-social behavior and decreases over-expenditure of effort, while improved information feedback decreases the heterogeneity of effort.
    Keywords: contest, information, identification, over-expenditure, experiments
    JEL: C72 C91 D72 D74
    Date: 2013–05–15
  15. By: Mahmoud Elamin
    Abstract: I show, under intuitive conditions on the risk-averse utility function, the nonoptimality of the Diamond and Dybvig (1983) contract in the Goldstein and Pauzner (2005) environment. If marginal utility at zero is low enough, then Goldstein and Pauzner (2005)’s claim about the optimality of the Diamond and Dybvig (1983) contract is true. When it is not, the optimal contract insures the patient depositor against a project default. The contract may exhibit risk-sharing with the impatient depositor. Unlike when Goldstein and Pauzner (2005)’s claim is correct, relative risk aversion greater than 1 does not necessarily make the optimal bank contract run-prone. I present a condition under which it is.
    Date: 2013
  16. By: Andrei Barbos (Department of Economics, University of South Florida)
    Abstract: This paper studies information acquisition under competitive pressure and proposes a model to examine the relationship between product market competition and the level of innovative ac- tivity in an industry. Our paper offers theoretical support for recent empirical results that point to an inverted-U shape relationship between competition and innovation. The model presents an optimal timing decision problem where a firm endowed with an idea trades the benefits of waiting for additional information on whether this idea can be converted into a successful project against the cost of delaying innovation: a given firm's profit following innovation is decreasing in the number of firms that invested at earlier dates. By recognizing that a firm can intensify its innovative activity on two dimensions, a risk dimension and a quantitative dimension, we show that firms solve this trade-off precisely so as to generate the inverted-U shape relationship.
    Keywords: Innovation, Information Acquisition, Timing Games, Preemption
    JEL: D40 L10
    Date: 2013–01
  17. By: Pedro Robalo (University of Amsterdam); Rei S. Sayag (Erasmus University Rotterdam)
    Abstract: The supposed irrelevance of historical costs for rational decision making has been the subject of much interest in the economic literature. In this paper we explore whether individual decision making under risk is affected by the cost of the supplied information. Outside of the lab, it is difficult to disentangle the effect of the cost of information itself from the effect of self-selection by individuals who tend to gain the most from this information. We thus create an environment in the lab where subjects are offered additional, useful and identical information on the state of the world across treatments. By varying the cost of information we can distinguish between selection and sunk cost effects. We find a systematic effect of sunk costs on the manner in which subjects update their beliefs on the state of the world. Subjects over-weigh costly information relatively to free information, which results in a 'push' of beliefs towards the extremes. This shift does not necessarily lead to behavior more attuned with Bayesian updating.
    Keywords: sunk cost, information, Bayesian updating, decision under risk, heuristics and biases, lab experiment
    JEL: C91 D81 D83
    Date: 2012–12–14
  18. By: Berliant, Marcus; Tabuchi, Takatoshi
    Abstract: We consider information aggregation in national and local elections when voters are mobile and might sort themselves into local districts. Using a standard model of private information for voters in elections in combination with a New Economic Geography model, agglomeration occurs for economic reasons whereas voter stratification occurs due to political preferences. We compare a national election, where full information equivalence is attained, with local elections in a three-district model. We show that full information equivalence holds at a stable equilibrium in only one of the three districts when transportation cost is low. The important comparative static is that full information equivalence is a casualty of free trade. When trade is more costly, people tend to agglomerate for economic reasons, resulting in full information equivalence in the political sector. Under free trade, people sort themselves into districts, most of which are polarized, resulting in no full information equivalence in these districts. We examine the implications of the model using data on corruption in the legislature of the state of Alabama and in the Japanese Diet.
    Keywords: information aggregation in elections; informative voting; new economic geography; local politics
    JEL: D72 D82 R12
    Date: 2013–05–15
  19. By: Alexander Rasch (University of Cologne); Christian Waibel (ETH Zurich, Switzerland)
    Abstract: This paper investigates the impact of four key economic variables on an expert firm’s incentive to defraud its customers in a credence goods market: the level of competition, the expert firm’s financial situation, its competence, and its reputational concerns. We use and complement the dataset of a nationwide field study conducted by the German Automobile Association that regularly checks the reliability of garages in Germany. We find that more intense competition and high competence lower firms’ incentive to overcharge. A low concern for reputation and a critical financial situation increase the incentive to overcharge.
    Keywords: Asymmetric information; Auto repair market; Credence goods; Expert; Fraud; Overcharging.
    JEL: D82 L15
    Date: 2013–05
  20. By: Stefan Arping (University of Amsterdam)
    Abstract: We examine the impact CDS protection on lending relationships and efficiency. CDS insulate lenders against losses from forcing borrowers into default and liquidation. This improves the credibility of foreclosure threats, which can have positive implications for borrower incentives and credit availability ex ante. However, lenders may also abuse their enhanced bargaining power vis-a-vis borrowers and extract additional surplus in debt renegotiations. If this hold up threat becomes severe, borrowers will be reluctant to agree to debt maturity designs or control right transfers that would have been optimal in the absence of CDS protection. The introduction of CDS markets may then ultimately tighten credit constraints and be detrimental to welfare.
    Keywords: Corporate Lending; Financial Innovation; Credit Default Swaps; Credit Derivatives; Credit Risk Transfer; Empty Creditor Problem
    JEL: G2 G3
    Date: 2012–12–12
  21. By: Stefan Arping (University of Amsterdam); Sonia Falconieri (Brunel University)
    Abstract: Strategic investors, such as corporate venture capitalists, engage in the financing of start-up firms to complement their core businesses and to facilitate the internalization of externalities. We argue that while strategic objectives make it more worthwhile for an investor to elicit high entrepreneurial effort, they can also undermine his commitment to penalize poorly performing entrepreneurs by terminating their projects. Based on this tradeoff we develop a theory of financing choice between strategic and financial investors. Our framework provides insights into the design of corporate venturing deals and the choice between corporate venturing and independent venture capital finance.
    Keywords: Corporate Venturing, Soft Budget Constraint
    JEL: G20 G24 G32
  22. By: Rei S. Sayag (Erasmus University Rotterdam); Otto H. Swank (Erasmus University Rotterdam)
    Abstract: At the start of their term, politicians often announce which issue they intend to address. To shed light on this agenda setting, we develop a model in which a politician has to decide whether or not to address a public issue. Addressing an issue means that the politician investigates the issue and next chooses for either a major reform or a minor reform. Not addressing an issue means that the status quo is maintained. Politicians differ in their ability to make correct decisions. They want to make good decisions and want to come across as able decision makers. An important characteristic of the model is that politicians and voters have different priors concerning the desirability of a major reform. We show that electoral concerns may lead to anti-pandering. Politicians tend to put issues on their political agenda when voters are relatively pessimistic about a major reform, and keep issues off the table when voters are optimistic about major reform.
    Keywords: Agenda Setting, Career concerns, Pandering
    JEL: D72 D78 D82 P16
    Date: 2012–11–27
  23. By: Jurjen J.A. Kamphorst (Erasmus University Rotterdam); Otto H. Swank (Erasmus University Rotterdam)
    Abstract: In many organizations, reward decisions depend on subjective performance evaluations. However, evaluating an employee's performance is often difficult. In this paper, we develop a model in which the employee is uncertain about his own performance and about the manager's ability to assess him. The manager gives an employee a performance appraisal with a view of affecting the employee's self perception, and the employee's perception of the manager's ability to assess performance. We examine how performance appraisals affect the employee's future performance. The predictions of our model are consistent with various empirical findings. These comprise (i) the observation that managers tend to give positive appraisals, (ii) the finding that on average positive appraisals motivate more than negative appraisals, and (iii) the observation that the effects of appraisals depend on the employee's perception of the manager's ability to assess performance accurately.
    Keywords: Subjective Performance Appraisal, Credibility, Cheap Talk
    JEL: M52 M54 D82 D83
    Date: 2012–04–10

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