nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒06‒24
seventeen papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Subjective evaluation versus public information By Bester, Helmut; Münster, Johannes
  2. Exit options and the allocation of authority By Bester, Helmut; Krähmer, Daniel
  3. Committee Design with Endogenous Participation By Volker Hahn
  4. Costly Monitoring, Dynamic Incentives, and Default By Gaetano Antinolfi
  5. Hips and hearts: the variation in incentive effects of insurance across hospital procedures By Denise Doiron; Denzil G Fiebig; Agne Suziedelyte
  6. Wondering How Others Interpret It: Social Value of Public Information By Alia Gizatulina
  7. Combating fraud in Poverty-Alleviation Programs - should we use monitoring, workfare or both? By Márcia Ferreira de Oliveira; Cesaltina Pacheco Pires; Paulo Côrte-Real
  8. Bank Bonuses and Bail-Outs By Hendrik Hakenes; Isabel Schnabel
  9. National School Lunch Program Menus: A Moral Hazard Problem By Capogrossi, Kristen; You, Wen
  10. Auctions with imperfect commitment when the reserve may signal the auctioneer's type By Jun, Byoung Heon; Wolfstetter, Elmar G.
  11. Traceability in a Supply Chain with Repeated Double Moral Hazard By Saak, Alexander E.
  12. Efficient Risk Sharing with Limited Commitment and Storage By Árpád Ábrahám; Sarolta Laczóó
  13. Political Economy of Crop Insurance Risk Subsidies under Imperfect Information By Bulut, Harun; Collins, Keith J.
  14. Elections, Information, and State-Dependent Candidate Quality By Thomas Jensen
  15. Cooperation under punishment: Imperfect information destroys it and centralizing punishment does not help By Sven Fischer; Kristoffel Grechenig; Nicolas Meier
  16. Moral Hazard, Risks and Index Insurance in the Rural Credit Market: A Framed Field Experiment in China By Cheng, Lan
  17. An experimental study on the incentives of the probabilistic serial mechanism By Hugh-Jones, David; Kurino, Morimitsu; Vanberg, Christoph

  1. By: Bester, Helmut; Münster, Johannes
    Abstract: This paper studies a principal-agent relation in which the principal's private information about the agent's effort choice is more accurate than a noisy public performance measure. For some contingencies the optimal contract has to specify ex post inefficiencies in the form of inefficient termination (firing the agent) or third-party payments (money burning). We show that money burning is the less efficient incentive device: it is used at most in addition to firing and only if the loss from termination is small. Under an optimal contract the agent's wage may depend only on the principal's report and not on the public signal. Nonetheless, public information is valuable as it facilitates truthful subjective evaluation by the principal. --
    Keywords: subjective evaluation,moral hazard,termination clauses,third-party payments
    JEL: D23 D82 D86 J41 M12
    Date: 2013
  2. By: Bester, Helmut; Krähmer, Daniel
    Abstract: We analyze the optimal allocation of authority in an organization whose members have conflicting preferences. One party has decision-relevant private information, and the party who obtains authority decides in a self-interested way. As a novel element in the literature on decision rights, we consider exit option contracts: the party without decision rights is entitled to prematurely terminate the relation after the other party's choice. We show that under such a contract it is always optimal to assign authority to the informed and not to the uninformed party, irrespective of the parties' conflict of interest. Indeed, the first-best efficient solution can be obtained by such a contract. --
    Keywords: authority,decision rights,exit options,incomplete contracts,asymmetric information
    JEL: D23 D82 D86
    Date: 2013
  3. By: Volker Hahn (Department of Economics, University of Konstanz, Germany)
    Abstract: We investigate the optimal design of a committee in a model with the endogenous participation of experts who have private information about their own abilities. We study three different dimensions of committee design: members' wages, the number of seats, and the communication system. We show that, surprisingly, higher wages lead to lower quality experts. By contrast, transparency improves the quality of experts on the committee. We provide a complete characterization of optimal committees. They are characterized by low wages and can be transparent or opaque. An increase in the significance of the decision requires a larger optimal committee, but does not call for different wages or for another communication system. Finally, we prove that the optimal committee design represents the best possible mechanism for the principal.
    Keywords: Committee decision-making, information aggregation, adverse selection, efficiency wages, transparency, career concerns
    JEL: D71 D82 J45
    Date: 2013–06–12
  4. By: Gaetano Antinolfi (Washington University)
    Abstract: We study dynamic contracts between a lender and a borrower in the presence of costly state verification and hidden effort. The optimal contract minimizes social losses by mediating dynamic incentives and monitoring. Along the efficiency frontier, the threat of early termination is unavoidable for low levels of the borrower's promised utility; as the level increases, preventive monitoring is used to avoid future inefficient termination of the contractual relationship due to asymmetric information; for high level of promised utility, the threat of termination of the contractual relationship is no longer a useful tool to align dynamic incentives, preventive monitoring loses its role, and termination never occurs. Thus, the efficient contract optimizes the tradeoff between dynamic incentives and static incentives. Following the interpretation of the costly state verification literature, we can distinguish two levels of bankruptcy: one that leads to monitoring and the other that leads to liquidation.
    Date: 2012
  5. By: Denise Doiron (School of Economics, the University of New South Wales); Denzil G Fiebig (School of Economics, the University of New South Wales); Agne Suziedelyte (School of Economics, the University of New South Wales)
    Abstract: The separate identification of effects due to incentives, selection and preference heterogeneity in insurance markets is the topic of much debate. In this paper, we investigate the presence and variation in moral hazard across health care procedures. The key motivating hypothesis is the expectation of larger causal effects in the case of more discretionary procedures. The empirical approach relies on an extremely rich and extensive dataset constructed by linking survey data to administrative data for hospital medical records. Using this approach we are able to provide credible evidence of large moral hazard effects but for elective surgeries only.
    Keywords: health insurance, asymmetric information, moral hazard
    JEL: D82 I11
    Date: 2013–06
  6. By: Alia Gizatulina (Max Planck Institute for Research on Collective Goods, Bonn)
    Abstract: This paper studies the social value of public information in environments without common knowledge of the data-generating process. We show that the stronger the coordination motive behind agents’ behaviour is, the more they use private or public signals in the way that they suspect others are doing it. Consequently, the negative impact of public communication noted by Morris and Shin (2002) can be amplified if agents suspect that others take the public signal too literally and/or are too inattentive to their private signals. Social welfare, if measured as in Morris and Shin (2002), always increases in the precision of the public signal when each agent evaluates its precision correctly, but believes that others did not understand the public signal at all, which suggests that there is a scope to “obliterate” public communication in a specific way, by making it, e.g., sophisticated and technical. By contrast, measuring welfare as in Woodford (2005) reverses, in general, desirability for such obliteration and non-commonality of signals’ understanding.
    Keywords: transparency, central bank communication, common p-belief, coordination game, higher-order uncertainty
    JEL: D82 E58
    Date: 2013–04
  7. By: Márcia Ferreira de Oliveira (CEFAGE-UE and Instituto Politécnico de Portalegre, Portugal); Cesaltina Pacheco Pires (CEFAGE-UE, Departamento de Gestão, Universidade de Évora, Portugal); Paulo Côrte-Real (Nova School of Business and Economics, INOVA, Universidade Nova de Lisboa)
    Abstract: This paper presents a static model of adverse selection where the government (principal) aims to minimize the cost of a Poverty Alleviation Program (PAP) ensuring that all agents have access to a minimum level of income. In a two-type-agent model (Rich and Poor) in which agents differ either on their income generating ability or in their disutility of labour, we study the effectiveness of workfare and monitoring as tools to prevent fraud in PAP. When only income generating ability is unknown, we show that the optimal PAP depends on the fraction of Rich agents, the costs of monitoring and the productivity gap between the two types. Thus, the optimal solution might use (a) only workfare; (b) only monitoring; (c) a combination of both; or (d) none of the instruments. When agents differ only in disutility of labour, the optimal PAP does not include workfare. It is shown that the greater the fraction of Rich Type agents and the higher the income differential, the more likely is that the optimal solution includes monitoring.
    Keywords: Poverty alleviation programs, workfare, monitoring, fraud, adverse selection.
    JEL: D82 I38
    Date: 2013
  8. By: Hendrik Hakenes (University of Bonn, Finance Department); Isabel Schnabel (Gutenberg School of Management and Economics, Johannes Gutenberg University Mainz)
    Abstract: This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bail-outs. If there is a risk-shifting problem, bail-out expectations lead to steeper bonus schemes and even more risk-taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bailout perceptions makes it optimal for a welfare-maximizing regulator to impose caps on bank bonuses. In contrast, raising managers’ liability can be counterproductive.
    Keywords: bonus payments, bank bail-outs, bank management compensation, risk-shifting, underinvestment, limited and unlimited liability
    JEL: J33 G21 G28 M52
    Date: 2013–02
  9. By: Capogrossi, Kristen; You, Wen
    Abstract: Decisions are made daily concerning many facets of the National School Lunch Program at the federal, state and local levels, but how are decisions made with regard to the actual choice of foods on school lunch menus? No study that we are aware of examines the incentives and barriers among the SFAs decision-making process with regard to the provision of healthier lunch menus. The issue faced by SFAs is a classic moral hazard problem: a SFA’s effort for the provision of healthy menu options is unknown (i.e., hidden actions). SFAs can accept federal funds and agricultural commodities to provide healthy lunches while districts create school wellness policies “requiring” minimum nutritional quality of school-provided foods, but the overall quality of implementation and compliance are not observable. This paper utilizes the Principal-Agent (PA) theory to model this moral hazard problem and unveil the barriers and incentive targets and channels behind the observed inefficient school nutrition policy implementation.
    Keywords: Nutrition Programs, Child Health, Policy, Food Consumption/Nutrition/Food Safety, Food Security and Poverty, Health Economics and Policy,
    Date: 2013
  10. By: Jun, Byoung Heon; Wolfstetter, Elmar G.
    Abstract: If bidders are uncertain whether the auctioneer sticks to the announced reserve, some bidders respond by not bidding, speculating that the auctioneer may revoke the reserve. However, the reserve inadvertently signals the auctioneer's type, which drives a unique separating and a multitude of pooling equilibria. If one eliminates belief systems that violate the "intuitive criterion", one obtains a unique equilibrium reserve price equal to the seller's own valuation. Paradoxically, even if bidders initially believe that the auctioneer is bound by his reserve almost with certainty, commitment has no value.
    Keywords: Auctions; signalling; mechanism design
    JEL: D21 D43 D44 D45
    Date: 2013–06–18
  11. By: Saak, Alexander E.
    Abstract: Recent food safety events have raised concerns about adoption of traceability systems. The paper studies the question of when and why a supply chain should invest in an upstream traceability system that allows identifying which supplier is responsible for quality defects due to insufficient (non-contractible) effort when firms interact repeatedly. The downstream firm and consumers observe imperfect, lagged signals of input and output quality. Without appealing to exogenous cost for a traceability system, it is demonstrated that in deciding whether to maintain information regarding product origin, firms face a trade-off. On one hand, the downstream firm is tempted to condone limited upstream shirking or resort to an experimentation strategy to identify the upstream shirker when products are not traceable to their firm of origin. On the other hand, the downstream firm is tempted to “vertically coordinate” shirking in the provision of quality when products are traceable. Colluding with a subset of upstream firms is more attractive when the downstream firm can tell whether a product originates from a shirking or non-shirking firm. Firms achieve greater joint profits when products are not traceable to upstream suppliers if (1) the ratio of the cost savings from upstream shirking and downstream shirking is neither too large nor too small or (2) the probability with which the downstream firm detects input defects is not too large or (3) the consumer experience is a sufficiently noisy signal of quality. It is also shown that the returns to more precise inter-firm monitoring can increase or decrease after the adoption of a traceability system depending on information generated by consumer experience.
    Keywords: Food Consumption/Nutrition/Food Safety, Industrial Organization,
    Date: 2013
  12. By: Árpád Ábrahám; Sarolta Laczóó
    Abstract: We extend the model of risk sharing with limited commitment (Kocherlakota, 1996) by introducing both a public and a private (non-contractible and/or non-observable) storage technology. Positive public storage relaxes future participation constraints and may hence improve risk sharing, contrary to the case where hidden income or effort is the deep friction. The characteristics of constrained-efficient allocations crucially depend on the storage technology’s return. In the long run, if the return on storage is (i) moderately high, both assets and the consumption distribution may remain time-varying; (ii) sufficiently high, assets converge almost surely to a constant and the consumption distribution is time-invariant; (iii) equal to agents’ discount rate, perfect risk sharing is self-enforcing. Agents never have an incentive to use their private storage technology, i.e., Euler inequalities are always satisfied, at the constrained-efficient allocation of our model, while this is not the case without optimal public asset accumulation.
    Keywords: risk sharing, limited commitment, hidden storage, dynamic contracts
    JEL: E20
    Date: 2013–04
  13. By: Bulut, Harun; Collins, Keith J.
    Abstract: We consider a political economy where government cares about risk-averse farmers’ loss of income and yet incurs political cost if it provides monetary support to farmers. Government evaluates three options: 1) ex-post disaster aid; 2) ex-ante insurance option with perfect information; 3) ex-ante insurance with imperfect information (farmers are over-confident about their risk). It is assumed that marginal political cost is high enough so that the possibility of monetary support to farmers in the absence of economic loss is ruled out. In comparing 1) and 2), we find that government prefers farmers manage their risks through fairly priced insurance In comparing 1) and 3), if the information problems prevent risk-averse farmers to take up full insurance under actuarially fair rates, government prefers to subsidize farmers’ insurance ex-ante rather than providing disaster aid ex-post (subject to political cost) for a wide range of parameter values.
    Keywords: Agricultural risk, crop insurance, disaster assistance, Agribusiness, Crop Production/Industries, Political Economy, Risk and Uncertainty, D81, G22, Q12, Q18,
    Date: 2013–06–06
  14. By: Thomas Jensen (Department of Economics, University of Copenhagen)
    Abstract: The quality of political candidates often depends on the current state of the world, for example because their personal characteristics are more valuable in some situations than in others. We explore the implications of state-dependent candidate quality in a model of electoral competition where voters are uncertain about the state. Candidates are fully informed and completely office-motivated. With a reasonable restriction on voters' ?beliefs, an equilibrium where candidates' ?positions reveal the true state does not exist. Non-revealing equilibria always exist. Some main findings are that canddates' ?positions can diverge more in equilibrium when they differ more in state-dependent quality and when the electorate is less well informed.
    Keywords: Electoral competition; Candidate quality; Uncertainty; Information; Polarization
    JEL: D72
    Date: 2013–02–20
  15. By: Sven Fischer (Max Planck Institute for Research on Collective Goods, Bonn); Kristoffel Grechenig (Max Planck Institute for Research on Collective Goods, Bonn); Nicolas Meier
    Abstract: We run several experiments which allow us to compare cooperation under perfect and imperfect information and under a centralized and decentralized punishment regime. We nd that (1) centralization by itself does not improve cooperation and welfare compared to an informal, peer-to-peer punishment regime and (2) centralized punishment is equally sensitive to noise as decentralized punishment, that is, it leads to signicantly lower cooperation and welfare (total prots). Our results shed critical light on the widespread conjecture that the centralization of punishment institutions is welfare increasing in itself.
    Keywords: Public Goods, cooperation, centralized punishment, imperfect information, decentralized punishment, peer to peer punishment
    JEL: C92 K42 H42 D03
    Date: 2013–04
  16. By: Cheng, Lan
    Abstract: Abstract This paper studies the interaction between index insurance market and the rural credit market by investigating how the availability of index insurance affects borrowers' moral hazard behavior. Among different types of moral hazard problem in the credit market, we focuses on credit diversion, which occurs when borrowers violate loan contracts and use some or all of production loans for consumption purpose. We build a theoretical model to show that credit non-diverters are likely to benefit from and purchase index insurance, while credit diverters are not. For credit non-diverters, index insurance provides consumption smoothing and increases future income by preventing loan default. For credit diverters who are already implicitly insured by diverting credit from risky investments to consumption, index insurance increases their consumption risks and can even lower expected consumption level. The fundamental reason for the difference of the impact between credit diverters and non-diverters is that index insurance pays indemnities based on external indices rather than farmers' realized outcome. Therefore, the availability of index insurance encourages farmers to choose full investment of loans instead of credit diversion. To test these theoretical predictions empirically, we conducted a framed field experiment with 450 rural households in the north region of China. Coinciding with theoretical predictions, experimental results show that index insurance reduces the number of credit diverters by 75.8%. The treatment effect on credit diversion is heterogeneous across farmers depending on their risk preferences and ethical costs associated with violating loan contracts. The theoretical and empirical results have important policy implications for stimulating credit supply to agriculture and reducing credit rationing. They suggest that lenders can use index insurance as a signaling instrument to overcome information asymmetry in the credit market. Index insurance can be substituted for collateral requirements and lessen both quantity and risk rationing caused by collateral requirement.
    Keywords: Moral Hazard, Index Insurance, Credit Market, Credit Rationing, Agricultural Finance, Institutional and Behavioral Economics, International Development, Risk and Uncertainty,
    Date: 2013
  17. By: Hugh-Jones, David; Kurino, Morimitsu; Vanberg, Christoph
    Abstract: We report an experiment on the Probabilistic Serial (PS) mechanism for allocating indivisible goods. The PS mechanism, a recently discovered alternative to the widely used Random Serial Dictatorship mechanism, has attractive fairness and efficiency properties if people report their preferences truthfully. However, the mechanism is not strategy-proof, so participants may not truthfully report their preferences. We investigate misreporting in a set of simple applications of the PS mechanism. We confront subjects with situations in which theory suggests that there is an incentive or no incentive to misreport. We find little misreporting in situations where misreporting is a Nash equilibrium. However, we also find a significant degree of misreporting in situations where there is actually no benefit in doing so. These findings suggest that the PS mechanism may have problems in terms of truthful elicitation. --
    Keywords: probabilistic serial mechanism,incentives
    JEL: C78 C91 C92
    Date: 2013

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