nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒09‒24
eleven papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Do Sellers Offer Menus of Contracts to Separate Buyer Types? An Experimental Test of Adverse Selection Theory By Hoppe, Eva I; Schmitz, Patrick W
  2. Optimal Student Loans and Graduate Tax under Moral Hazard and Adverse Selection By Gary-Bobo, Robert J.; Trannoy, Alain
  3. The effect of third-party funding of plaintiffs on settlement By Andrew Daughety; Jennifer Reinganum
  4. Information Management in Banking Crises By Shapiro, Joel; Skeie, David
  5. Central Bank Screening, Moral Hazard, and the Lender of Last Resort Policy By Mei Li; Frank Milne; Junfen Qiu
  6. Pooling Promises with Moral Hazard By Goulão, Catarina; Panaccione, Luca
  7. A Political Economy of the Separation of Electoral Origin By Buisseret, Peter
  8. The Real Costs of Disclosure By Alex Edmans; Mirko Heinle; Chong Huang
  9. Bayes Correlated Equilibrium and the Comparison of Information Structures By Dirk Bergemann; Stephen Morris
  10. Optimal Primaries By Patrick Hummel; Richard Holden
  11. Equilibria in Health Exchanges: Adverse Selection vs. Reclassification Risk By Benjamin R. Handel; Igal Hendel; Michael D. Whinston

  1. By: Hoppe, Eva I; Schmitz, Patrick W
    Abstract: In the basic adverse selection model, a seller makes a contract offer to a privately informed buyer. A fundamental hypothesis of incentive theory is that the seller may want to offer a menu of contracts to separate the buyer types. In the good state of nature, total surplus is not different from the symmetric information benchmark, while in the bad state, private information may be welfare-reducing. We have conducted a laboratory experiment with 954 participants to test these hypotheses. While the results largely corroborate the theoretical predictions, we also find that private information may be welfare-enhancing in the good state.
    Keywords: Incentive theory; Laboratory experiment; Mechanism design; Private information
    JEL: C72 C92 D82 D86
    Date: 2013–06
  2. By: Gary-Bobo, Robert J.; Trannoy, Alain
    Abstract: We completely characterize the set of second-best optimal "menus" of student-loan contracts in a simple economy with risky labour-market outcomes, adverse selection, moral hazard and risk aversion. The model combines structured student loans and an elementary optimal income-tax problem à la Mirrlees. This combination can be called a graduate tax. There are two categories of second-best optima: the equal treatment and the separating allocations. The equal treatment case is obtained when the social weights of student types are close to their population frequencies; the expected utilities of different types are then equalized, conditional on the event of success on the labor market. But individuals are ex ante unequal because of differing probabilities of success, and ex post unequal, because the income tax trades off incentives and insurance (redistribution). In separating optima, the talented types bear more risk than the less-talented ones; they arise only if the social weight of the talented types is sufficiently high. The second-best optimal graduate tax provides incomplete insurance because of moral hazard; it typically involves cross-subsidies; generically, it cannot be decomposed as the sum of an optimal income tax depending only on earnings, and a loan repayment, depending only on education. Therefore, optimal loan repayments must be income-contingent.
    Keywords: asymmetric information; higher education; mechanism design; optimal taxation; student loans
    JEL: D82 H21 I22 I24
    Date: 2013–06
  3. By: Andrew Daughety (Department of Economics and Law School, Vanderbilt University); Jennifer Reinganum (Department of Economics and Law School, Vanderbilt University)
    Abstract: In this paper we use a signaling model to analyze the effect of (endogenously-determined) third-party non-recourse loans to plaintiffs on settlement bargaining when a plaintiff has private information about the value of her suit. We show that an optimal loan (i.e., one that maximizes the joint expected payoff to the litigation funder and the plaintiff) induces full settlement. Furthermore, in contrast with the more standard (no-loan) settlement bargaining models, there is no revelation of information created by the bargaining process: all plaintiff types (where the plaintiff's type is her level of harm) make the same demand and, since no types go to trial, private information is not revealed. Implementation of the loan may entail a very high interest rate; we show that a high (enough) rate is necessary if one wants to obtain full settlement for all types of plaintiffs even when there is asymmetric information. We also find that plaintiffs' lawyers benefit from such financing, as it reduces their costs by eliminating the need to take the case to trial due to bargaining breakdown. We further show that regulation of such loans, in the form of caps on the interest charged, may result in settlement failure or elimination of the litigation-funding industry itself.
    Keywords: settlement bargaining, litigation funding, non-recourse loan, signaling
    JEL: K4 D8
    Date: 2013–02–13
  4. By: Shapiro, Joel; Skeie, David
    Abstract: A regulator resolving a bank faces two audiences: depositors, who may run if they believe the regulator will not provide capital, and banks, which may take excess risk if they believe the regulator will provide capital. When the regulator's cost of injecting capital is private information, it manages expectations by using costly signals: (i) A regulator with a low cost of injecting capital may forbear on bad banks to signal toughness and reduce risk taking, and (ii) A regulator with a high cost of injecting capital may bail out bad banks to increase confidence and prevent runs. Regulators perform more informative stress tests when the market is pessimistic.
    Keywords: bank regulation; financial crisis; reputation; sovereign debt crisis; stress tests
    JEL: G01 G21 G28
    Date: 2013–08
  5. By: Mei Li (University of Guelph); Frank Milne (Queen's University); Junfen Qiu (Central University of Finance and Economics)
    Abstract: This paper establishes a theoretical model to examine the LOLR policy when a central bank cannot distinguish between solvent and insolvent banks. We study two cases: a case where the central bank cannot screen insolvent banks and a case where the central bank can only imperfectly screen insolvent banks. The major results that our model produces are as follows: (1) It is impossible for any separating equilibrium to exist because insolvent banks always have an incentive to mimic solvent banks to gamble for resurrection. (2) The pooling equilibria in which, on one hand, all the banks borrow from the central bank and, on the other hand, all the banks do not borrow from the central bank, could exist given certain market beliefs off the equilibrium path. However, neither of the equilibria is socially efficient because insolvent banks will continue to hold their unproductive assets, rather than efficiently liquidating them. (3) When the central bank can screen banks imperfectly, the pooling equilibrium where all the banks borrow from the central bank becomes more likely, and the pooling equilibrium where all the banks do not borrow from the central bank becomes less likely. (4) Higher precision in central bank screening will improve social welfare not only by identifying insolvent banks and forcing them to efficiently liquidate their assets, but also by reducing moral hazard and deterring banks from choosing risky assets in the first place. (5) If a central bank can commit to a specific precision level before the banks choose their assets, rather than conducting a discretionary LOLR policy, it will choose a higher precision level to reduce moral hazard and will attain higher social welfare.
    Keywords: Central Bank Screening, Moral Hazard, Lender of Last Resort
    JEL: D82 G2
    Date: 2013–09
  6. By: Goulão, Catarina (TSE (Gremaq, Inra)); Panaccione, Luca ((DEDI and CEIS))
    Date: 2013–08–29
  7. By: Buisseret, Peter (Department of Economics, University of Warwick)
    Abstract: Political constitutions frequently separate the roles of proposer and veto player in policy-making processes. A fundamental distinction lies in whether both offices are subject to direct and separate election, or whether the voter instead may directly elect the holder of only one office. In the latter case, the voter constitutionally forfeits a degree of ex-post electoral control. Why should she benefit from such a relatively coarse electoral instrument? When politicians' abilities are private information, actions taken by one agent provide information to the voter about both agents' types. A system in which the electoral fate of these agents is institutionally fused reduces the incentives of the veto player to build reputation through the specious rejection of the proposer's policy initiatives. This can improve the voter's inference about the types of politicians and her welfare, relative to a system in which the survival of the veto player is institutionally separated from that of the proposer. JEL classification: JEL codes:
    Date: 2013
  8. By: Alex Edmans; Mirko Heinle; Chong Huang
    Abstract: This paper models the effect of disclosure on real investment. We show that, even if the act of disclosure is costless, a high-disclosure policy can be costly. Some information ("soft") cannot be disclosed. Increased disclosure of "hard" information augments absolute information and reduces the cost of capital. However, by distorting the relative amounts of hard and soft information, increased disclosure induces the manager to improve hard information at the expense of soft, e.g. by cutting investment. Investment depends on asset pricing variables such as investors' liquidity shocks; disclosure depends (non-monotonically) on corporate finance variables such as growth opportunities and the manager's horizon. Even if a low disclosure policy is optimal to induce investment, the manager may be unable to commit to it. If hard information turns out to be good, he will disclose it regardless of the preannounced policy. Government intervention to cap disclosure can create value, in contrast to common calls to increase disclosure.
    JEL: G18 G31
    Date: 2013–09
  9. By: Dirk Bergemann; Stephen Morris
    Date: 2013–09–19
  10. By: Patrick Hummel; Richard Holden
    Abstract: We analyze a model of US presidential primary elections for a given party. There are two candidates, one of whom is a higher quality candidate. Voters reside in m different states and receive noisy private information about the identity of the superior candidate. States vote in some order, and this order is chosen by a social planner. We provide conditions under which the ordering of the states that maximizes the probability that the higher quality candidate is elected is for states to vote in order from smallest to largest populations and most accurate private information to least accurate private information.
    JEL: D71 D72 K19
    Date: 2013–08
  11. By: Benjamin R. Handel; Igal Hendel; Michael D. Whinston
    Abstract: This paper studies regulated health insurance markets known as exchanges, motivated by their inclusion in the Affordable Care Act (ACA). We use detailed health plan choice and utilization data to model individual-level projected health risk and risk preferences. We combine the estimated joint distribution of risk and risk preferences with a model of competitive insurance markets to predict outcomes under different regulations that govern insurers' ability to use health status information in pricing. We investigate the welfare implications of these regulations with an emphasis on two potential sources of inefficiency: (i) adverse selection and (ii) premium reclassification risk. We find that market unravelling from adverse selection is substantial under the proposed pricing rules in the Affordable Care Act (ACA), implying limited coverage for individuals beyond the lowest coverage (Bronze) health plan permitted. Although adverse selection can be attenuated by allowing (partial) pricing of health status, our estimated risk preferences imply that this would create a welfare loss from reclassification risk that is substantially larger than the gains from increasing within-year coverage, provided that consumers can borrow when young to smooth consumption or that age-based pricing is allowed. We extend the analysis to investigate some related issues, including (i) age-based pricing regulation (ii) exchange participation if the individual mandate is unenforceable and (iii) insurer risk-adjustment transfers.
    JEL: D82 G22 I11 I13 I18
    Date: 2013–09

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