nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒08‒31
nine papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Incentive to Reduce Cost under Incomplete Information By Aditi Sengupta
  2. Status, incentives and random favouritism By Dey, Oindrila; Banerjee, Swapnendu
  3. Limited higher order beliefs and the welfare effects of public information By Camille Cornand; Frank Heinemann
  4. Intermediating Adverse Selection By Vincent Glode; Christian Opp
  5. Adverse selection and moral hazard in anonymous markets By Klein, Tobias J.; Lambertz, Christian; Stahl, Konrad O.
  6. Migration and Cross-Border Financial Flows By Kugler, Maurice; Levintal, Oren; Rapoport, Hillel
  7. Learning and Evolution of Trading Strategies in Limit Order Markets By Carl Chiarella; Xue-Zhong He; Lijian Wei
  8. Default and Renegotiation in PPP Auctions By Matthew Ryan; Flávio Menezes
  9. The Market for "Rough Diamonds": Information, Finance and Wage Inequality By Theodore Koutmeridis

  1. By: Aditi Sengupta
    Abstract: I examine how ex ante symmetric firms that compete in prices strategically decide to invest in research and development of cost-reducing technology when the rival firm and the consumers are not aware of the actual outcome of the investment. I also compare the strategic incentive to invest and market outcomes under incomplete information with that of the full information. I find that equilibrium investment under incomplete information with unobservable investment is same as that of (symmetric) full information equilibrium and is also socially optimal.
    Keywords: Cost-reducing technology; Duopoly; Incomplete information; Price competition; Strategic investment
    JEL: D43 D82 L13
    Date: 2013–08
  2. By: Dey, Oindrila; Banerjee, Swapnendu
    Abstract: The paper identifies a condition under which favouritism is beneficial to the principal even when the favoured agent is selected randomly. This paper also characterizes how the optimal incentive scheme changes in presence of random favouritism. Using a moral hazard framework with limited liability it is shown that in presence of favouritism principal can optimally decrease monetary incentive when the potentially favoured group size is small. Inspite of a fall in optimal effort the paper predicts that favouritism can emerge as an optimal outcome when return of the firm is low.
    Keywords: Favouritism, status-incentives, non-verifiability, moral hazard, optimal contract
    JEL: D86 L14 L20
    Date: 2013–06–01
  3. By: Camille Cornand (GATE Lyon Saint-Etienne - Groupe d'analyse et de théorie économique - CNRS : UMR5824 - Université Lumière - Lyon II - École Normale Supérieure - Lyon); Frank Heinemann (Fachgebiet Makroökonomik - Technische Universität Berlin)
    Abstract: In games with strategic complementarities, public information about the state of the world has a larger impact on equilibrium actions than private information of the same precision, because the former is more informative about the likely behavior of others. This may lead to welfare-reducing 'overreactions' to public signals as shown by Morris and Shin (2002). Recent experiments on games with strategic complementarities show that subjects attach a lower weight to public signals than theoretically predicted. Aggregate behavior can be better explained by a cognitive hierarchy model where subjects employ limited levels of reasoning. This paper analyzes the welfare effects of public information under such limited levels of reasoning and argues that for strategies according with experimental evidence, public information that is more precise than private information cannot reduce welfare, unless the policy maker has instruments that are perfect substitutes to private actions.
    Keywords: coordination games; strategic uncertainty; private information; public information; higherorder beliefs; levels of reasoning
    Date: 2013–08–28
  4. By: Vincent Glode (Wharton School); Christian Opp (University of Pennsylvania)
    Abstract: We propose a parsimonious model of over-the-counter trading under asymmetric information to study the presence of intermediary chains that stand between well informed parties and uninformed market participants. Multiple moderately informed intermediaries can fulfill an important economic role of "smoothing" adverse selection. Informed market participants may prefer to trade through these intermediary chains as they improve trade efficiency but also reduce the surplus accruing to uninformed traders. Our model makes novel predictions about optimal network formation when adverse selection problems impede the efficiency of trade.
    Date: 2013
  5. By: Klein, Tobias J.; Lambertz, Christian; Stahl, Konrad O.
    Abstract: We study the effects of improvements in eBay's rating mechanism on seller exit and continuing sellers' behavior. Following a large sample of sellers over time, we exploit the fact that the rating mechanism was changed to reduce strategic bias in buyer rating. That improvement did not lead to increased exit of poorly rated sellers. Yet, buyer valuation of the staying sellers-especially the poorly rated ones-improved significantly. By our preferred interpretation, the latter effect results from increased seller effort; also, when sellers have the choice between exiting (a reduction in adverse selection) and improved behavior (a reduction in moral hazard), then they prefer the latter because of lower cost. -- Anonyme Märkte wie solche, die im Internet tagtäglich geöffnet werden, sind gekennzeichnet durch asymmetrische Information zwischen den Marktteilnehmern. Tatsächlich weiß die Käuferin vor dem Tauschakt nicht, ob der Verkäufer das Gut korrekt beschrieben hat, und ob er nach ihrer Kaufentscheidung die Transaktion gewissenhaft durchführt. Ohne Abhilfe lösen diese Informationsasymmetrien Adverse Selektion und Moralisches Risiko aus: Adverse Selektion entsteht dadurch, dass gewissenhafte Verkäufer den Markt verlassen (oder erst gar nicht in ihn eintreten), solange ihre Gewissenhaftigkeit durch die Käufer mangels korrekter ex ante Information nicht honoriert wird. Moralisches Risiko entsteht dadurch, dass aus dem gleichen Grund die im Markt verbleibenden Verkäufer ihre Anstrengungen gering halten. Die Konsequenzen von Adverser Selektion und Moralischem Risiko sind inzwischen theoretisch sorgfältig analysiert und gut verstanden. Jedoch gibt es bisher wenige empirische Tests zu den aus der Theorie abgeleiteten Hypothesen. Internetmärkte bieten dafür eine nützliche Umgebung. Aufgrund der offensichtlichen Konsequenzen entwickelten die Designer von Internet-Märkten schon aus Eigeninteresse frühzeitig Instrumente zur Abwehr der adversen Effekte; vor allem in Form von Reputationsmechanismen, unter denen Käufer und Verkäufer ihre Performanz gegenseitig bewerten und daraus Reputationskapital entwickeln können. Diese Mechanismen wurden im Laufe der Zeit verbessert, in Reaktion auf opportunistisches Berichtsverhalten auf beiden Marktseiten.
    Keywords: Anonymous markets,adverse selection,moral hazard,reputation building mechanisms
    JEL: D83 L15
    Date: 2013
  6. By: Kugler, Maurice (United Nations Development Programme (UNDP)); Levintal, Oren (Bar-Ilan University); Rapoport, Hillel (Bar-Ilan University)
    Abstract: The gravity model has provided a tractable empirical framework to account for bilateral flows not only of manufactured goods, as in the case of merchandise trade, but also of financial flows. In particular, recent literature has emphasized the role of information costs in preventing larger diversification of financial investments. This paper investigates the role of migration in alleviating information imperfections between home and host countries. We show that the impact of migration on financial flows is strongest where information problems are more acute (that is, for more informational sensitive investments and between more culturally distant countries) and for the type of migrants that are most able to enhance the flow of information, namely, skilled migrants. We interpret these differential effects as additional evidence pointing to the role of information in generating home-bias and as new evidence of the role of migration in reducing information frictions between countries.
    Keywords: migration, international financial flows, international loans, gravity models, information asymmetries
    JEL: F21 F22 O1
    Date: 2013–08
  7. By: Carl Chiarella (Finance Discipline Group, UTS Business School, University of Technology, Sydney); Xue-Zhong He (Finance Discipline Group, UTS Business School, University of Technology, Sydney); Lijian Wei (Finance Discipline Group, UTS Business School, University of Technology, Sydney)
    Abstract: How do traders process and learn from market information, what trading strategies should they use, and how does learning affect the market? This paper proposes a learning model of an articial limit order market with asymmetric information to address these issues. Using a genetic algorithm as a learning mechanism, we show that learning, in particular the learning from uninformed traders, improves market informational efficiency and has a significant impact on the stylized facts of limit order markets, order submission, liquidity supply and consumption, the hump shaped order book near the quote, and the bid-ask spread. Moreover, the learning affects the evolution process of the trading strategies for all traders. The model provides some insights into market efficiency, the interaction of traders, the dynamics of limit order books, and the evolution of trading strategies.
    Keywords: Limit order book; evolution; genetic algorithm learning; asymmetric information; trading strategy
    JEL: G14 C63 D82
    Date: 2013–08–01
  8. By: Matthew Ryan (The University of Auckland); Flávio Menezes (School of Economics, The University of Queensland)
    Abstract: The winners of auctions for PPP contracts, especially for major infrastructure projects such as highways, often enter financial distress, requiring the concession to either be re-allocated or re-negotiated. We build a simple model to identify the causes and consequences of such problems. In the model, firms bid toll charges for a fixed-term high- way concession, with the lowest bid winning the auction. The winner builds and operates the highway for the fixed concession period. Each bidder has a privately known construction cost and there is common uncertainty regarding the level of demand that will result for the com- pleted highway. Because it is costly for the Government to re-assign the concession, it is exposed to a hold-up problem, which bidders can exploit through the strategic use of debt. Each firm chooses its finan- cial structure to provide optimal insurance against downside demand risk: the credible threat of default is used to extort an additional transfer payment from the Government. We derive the optimal finan- cial structure and equilibrium bidding behaviour and show that (i) the auction remains efficient, but (ii) bids are lower than they would be if all bidders were cash financed, and (iii) the more efficient the winning firm, the more likely it is to require a Government bail-out.
    Date: 2013–08–20
  9. By: Theodore Koutmeridis (University of St. Andrews)
    Abstract: During the past four decades both between and within group wage inequality increased significantly in the US. I provide a microfounded justification for this pattern, by introducing private employer learning in a model of signaling with credit constraints. In particular, I show that when financial constraints relax, talented individuals can acquire education and leave the uneducated pool, this decreases unskilled-inexperienced wages and boosts wage inequality. This explanation is consistent with US data from 1970 to 1997, indicating that the rise of the skill and the experience premium coincides with a fall in unskilled-inexperienced wages, while at the same time skilled or experienced wages do not change much. The model accounts for: (i) the increase in the skill premium despite the growing supply of skills; (ii) the understudied aspect of rising inequality related to the increase in the experience premium; (iii) the sharp growth of the skill premium for inexperienced workers and its moderate expansion for the experienced ones; (iv) the puzzling coexistence of increasing experience premium within the group of unskilled workers and its stable pattern among the skilled ones. The results hold under various robustness checks and provide some interesting policy implications about the potential conflict between inequality of opportunity and substantial economic inequality, as well as the role of minimum wage policy in determining the equilibrium wage inequality.
    Keywords: wage inequality, experience premium, skill premium, employer learning, signaling, financial constraints, minimum wages
    JEL: D31 D82 E44 J31
    Date: 2013–08–01

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