nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2013‒11‒16
23 papers chosen by
Simona Fabrizi
Massey University, Albany

  1. Verifiable and Nonverifiable Information in a Two-Period Agency Problem By Budde, Jörg
  2. Skin in the Game and Moral Hazard By Chemla, Gilles; Hennessy, Christopher A.
  3. Extremal Information Structures in the First Price Auction By Dirk Bergemann; Benjamin Brooks; Stephen Morris
  4. Incentive Compatibility and Differentiability New Results and Classic Applications By Mailath, George J.; von Thadden, Ernst-Ludwig
  5. Moral Hazard, Informed Trading, and Stock Prices By Pierre Collin-Dufresne; Vyacheslav Fos
  6. Security bid auctions for agency contracts By Byoung Heon Jun; Elmar G. Wolfstetter
  7. Cooperative Games with Incomplete Information : Some Open Problems By Forges, Françoise; Serrano, Roberto
  8. Second-Degree Moral Hazard in a Real-World Credence Goods Market By Loukas Balafoutas; Rudolf Kerschbamer; Matthias Sutter
  9. Trust and Manipulation in Social Networks. By Manuel Förster; Ana Mauleon; Vincent Vannetelbosch
  10. Two-sided reputation in certification markets By Bouvard, Matthieu; Levy, Raphael
  11. Financing Constraints, Firm Dynamics, and International Trade By Till Gross; Stéphane Verani
  12. Auctions with imperfect commitment when the reserve may serve as a signal By Byoung Heon Jun; Elmar G. Wolfstetter
  13. Good news and bad news in subjective performance evaluation By Budde, Jörg
  14. Implementation of Communication Equilibria by Correlated Cheap Talk : the Two-Player Case By Forges, Françoise; Vida, Péter
  15. A Model of Product Design and Information Disclosure Investments By Panos Markopoulos; Kartik Hosanagar
  16. Rhetoric in legislative bargaining with asymmetric information By Chen, Ying; Eraslan, Hülya
  17. Migration to the Public Cloud By Tong Wang
  18. How to Screen Minersf Skills: Recruiting in the Coal Mining in Early Twentieth Century Japan By Sakai, Mayo
  19. Dynamic Financial Constraints: Distinguishing Mechanism Design from Exogenously Incomplete Regimes By Alexander Karaivanov; Robert M. Townsend
  20. Becoming the Neighbor Bidder: Endogenous Winner’s Curse in Dynamic Mechanisms By Alejandro Francetich
  21. Financial Obstacles and Inter-Regional Flow of Funds By Benjamin Moll; Robert M. Townsend; Victor Zhorin
  22. The Power of Whispers: A Theory of Rumor, Communication and Revolution By Yang Lu; Wing Suen; Heng Chen
  23. Moral Hazard and Economies of Scope in Physician Ownership of Complementary Medical Services By Brian K. Chen; Paul J. Gertler; Chuh-Yuh Yang

  1. By: Budde, Jörg
    Abstract: I examine how a firm’s opportunity to verify information influences the joint use of verifiable and unverifiable information for incentive contracting. I employ a simple two-period agency model, in which contract frictions arise from limited liability and the potential unverifiability of the principal’s information about the agent’s action. With short-term contract, the principal benefits from both a more informative and a more conservative verification of his private information. With long-term contracts, he may prefer a less informative verification, but his preference for a conservative verification persists.
    Date: 2013–10–23
  2. By: Chemla, Gilles; Hennessy, Christopher A.
    Abstract: What determines equilibrium securitization levels, and should they be regulated? To address these questions we develop a model where originators can exert unobservable effort to increase asset quality, subsequently having private information regarding quality when selling ABS to rational investors. In equilibrium, all originators have low/zero retentions if they are financially constrained and/or prices are su¢ ciently informative. Asymmetric information lowers effort incentives in all equilibria. Effort is promoted by junior retentions, investor sophistication, and informative prices. Optimal regulation promotes effort while accounting for investor-level externalities. It entails either a menu of junior retentions or a single junior retention with size decreasing in price informativeness. Mandated market opacity is only optimal amongst regulations failing to induce originator effort.
    Keywords: Securitization; skin in the game; risk-sharing; moral hazard;
    JEL: D61 D8 K22 G32 G28
    Date: 2013–01
  3. By: Dirk Bergemann (Cowles Foundation, Yale University); Benjamin Brooks (Dept. of Economics, Princeton University); Stephen Morris (Dept. of Economics, Princeton University)
    Abstract: We study how the outcomes of a private-value first price auction can vary with bidders' information, for a fixed distribution of private values. In a two bidder, two value, setting, we characterize all combinations of bidder surplus and revenue that can arise, and identify the information structure that minimizes revenue. The extremal information structure that minimizes revenue entails each bidder observing a noisy and correlated signal about the other bidder's value. In the general environment with many bidders and many values, we characterize the minimum bidder surplus of each bidder and maximum revenue across all information structures. The extremal information structure that simultaneously attains these bounds entails an efficient allocation, bidders knowing whether they will win or lose, losers bidding their true value and winners being induced to bid high by partial information about the highest losing bid. Our analysis uses a linear algebraic characterization of equilibria across all information structures, and we report simulations of properties of the set of all equilibria.
    Keywords: First price auction, Mechanism design, Robust predictions, Private information, Bayes correlated equilibrium
    JEL: C72 D44 D82 D83
    Date: 2013–11
  4. By: Mailath, George J.; von Thadden, Ernst-Ludwig
    Abstract: We provide several generalizations of Mailath's (1987) result that in games of asymmetric information with a continuum of types incentive compatibility plus separation implies differentiability of the informed agent's strategy. The new results extend the theory to classic models in finance such as Leland and Pyle (1977), Glosten (1989), and DeMarzo and Duffie (1999), that were not previously covered.
    Keywords: Adverse selection; separation; differentiable strategies; incentive compatibility
    JEL: C60 C73 D82 D83 G14
    Date: 2013–01–21
  5. By: Pierre Collin-Dufresne; Vyacheslav Fos
    Abstract: We analyze a model of informed trading where an activist shareholder accumulates shares in an anonymous market and then expends costly effort to increase the firm value. We find that equilibrium prices are affected by the position accumulated by the activist, because the level of effort undertaken is increasing in the size of his acquired position. In equilibrium, price impact has two components: one due to asymmetric information (as in the seminal Kyle (1985) model) and one due to moral hazard (a new source of illiquidity). Price impact is higher the more severe the moral hazard problem, which corresponds to a more productive activist. We thus obtain a trade-off: with more noise trading (less `price efficiency') the activist can build up a larger stake, which leads to more effort expenditure and higher firm value (more `economic efficiency').
    JEL: G0 G1 G10 G12 G14 G3 G34
    Date: 2013–11
  6. By: Byoung Heon Jun (Department of Economics, Korea University, Seoul, Republic of Korea); Elmar G. Wolfstetter (Institute of Economic Theory I, Humboldt University at Berlin, Spandauer Str. 1, 10178 Berlin, Germany)
    Abstract: A principal uses security bid auctions to award an incentive contract to one among several agents in the presence of hidden action and hidden information. Securities range from cash to equity and call options. ¡°Steeper¡± securities are better surplus extractors that narrow the gap between the two highest valuations, yet reduce effort incentives. In view of this trade-off, a hybrid share auction that includes a (possibly negative) cash reward to the winner, a minimum share, and an option to call a fixed wage contract, tends to outperform all other auctions, although it it is not an optimal mechanism. However, by adding output targets to hybrid share auctions one can (arbitrary closely) implement the optimal mechanism.
    Keywords: Auctions and security design, agency problems, mechanism design
    JEL: D21 D43 D44 D45
    Date: 2013
  7. By: Forges, Françoise; Serrano, Roberto
    Abstract: This is a brief survey describing some of the recent progress and open problems in the area of cooperative games with incomplete information. We discuss exchange economies, cooperative Bayesian games with orthogonal coalitions, and issues of cooperation in non-cooperative Bayesian games.
    Keywords: Strategic Externalities; Non-Cooperative Bayesian Games; Cooperative Games with Orthogonal Coalitions; Exchange Economies; Informational Externalities;
    JEL: D82 D51 C72 C71
    Date: 2013–06
  8. By: Loukas Balafoutas; Rudolf Kerschbamer; Matthias Sutter
    Abstract: Empirical literature on moral hazard focuses exclusively on the direct impact of asymmetric information on market outcomes, thus ignoring possible repercussions. We present a field experiment in which we consider a phenomenon that we call second-degree moral hazard – the tendency of the supply side in a market to react to anticipated moral hazard on the demand side by increasing the extent or the price of the service. In the market for taxi rides, our moral hazard manipulation consists of some passengers explicitly stating that their expenses will be reimbursed by their employer. This has an economically important and statistically significant positive effect on the likelihood of overcharging, with passengers in that treatment being about 13% more likely to pay higher-than-justified prices for a given ride. This indicates that second-degree moral hazard may have a substantial impact on service provision in a credence goods market.
    Keywords: Natural field experiment, credence goods, asymmetric information, moral hazard, overcharging, overtreatment, taxi
    JEL: C93 D82
    Date: 2013
  9. By: Manuel Förster (CORE - Université Catholique de Louvain et Centre d'Economie de la Sorbonne); Ana Mauleon (CORE - Université Catholique de Louvain et CEREC - Université Saint-Louis - Bruxelles); Vincent Vannetelbosch (Università di Trento and LEM Scuola Superiore Sant'Anna)
    Abstract: We investigate the role of manipulation in a model of opinion formation where agents have opinions about some common question of interest. Agents repeatedly communicate with their neighbors in the social network, can exert some effort to manipulate the trust of others, and update their opinions taking weighted averages of neighbors' opinions. The incentives to manipulate are given by the agents' preferences. We show that manipulation can modify the trust structure and lead to a connected society, and thus, make the society reaching a consensus. Manipulation fosters opinion leadership, but the manipulated agent may even gain influence on the long-run opinions. In sufficiently homophilic societies, manipulation accelerates (slows down) convergence if it decreases (increases) homophily. Finally, we investigate the tension between information aggregation and spread of misinformation. We find that if the ability of the manipulating agent is weak and the agents underselling (overselling) their information gain (lose) overall influence, then manipulation reduces misinformation and agents converge jointly to more accurate opinions about some underlying true state.
    Keywords: Social networks, trust, manipulation, opinion leadership, consensus, Wisdom of crowds.
    JEL: D83 D85 Z13
    Date: 2013–09
  10. By: Bouvard, Matthieu; Levy, Raphael
    Abstract: We consider a market where privately informed sellers resort to certification to overcome adverse selection. There is uncertainty about the certifier's ability to generate accurate information. The profit of a monopolistic certifier is an inverted U-shaped function of his reputation for accuracy: being perceived as more precise allows to attract more good sellers but a high expected precision also deters bad sellers. Since the certifier tries to reach a balanced reputation to attract both types, reputation has a disciplining effect when the certifier is perceived as insufficiently accurate, but gives incentives to decrease precision when he is perceived as “too" accurate. The impact of competition depends on whether sellers “multihome" or “singlehome". Under singlehoming, certifiers compete to attract good sellers, which makes higher reputation more valuable. Multihoming makes higher reputations less desirable because the competitor exerts a negative externality by providing extra information. Therefore, singlehoming attenuates bad reputation effects, while multihoming exacerbates inefficiencies.
    Date: 2013–10
  11. By: Till Gross (Department of Economics, Carleton University); Stéphane Verani (Federal Reserve Board)
    Abstract: This paper studies the impact of financial constraints on exporter dynamics, and the role of financial intermediation in international trade. We propose a two-country general equilibrium model economy in which entrepreneurs and lenders engage in longterm credit relationships. Financial markets are endogenously incomplete because of private information, and financial constraints arise as a consequence of optimal financial contracts. In equilibrium, competitive financial intermediaries actively channel individuals' short-term deposits to fund a diversified portfolio of long-term risky firms. Young and small firms operate below their efficient level, and their financial constraint is relaxed as the entrepreneur's claim to future cash- flows increases. Consistent with empirical regularities, there is a substantial year-to-year transition in and out of export markets for smaller firms, and new exporters account only for a small share of total exports. Established ex-porters are less likely to exit export markets and tend to experience slower, albeit more stable growth.
    Keywords: private information, dynamic optimal contracts, exporter dynamics, financial intermediation
    JEL: F10 D82 L14
    Date: 2013–09–13
  12. By: Byoung Heon Jun (Department of Economics, Korea University, Seoul, Republic of Korea); Elmar G. Wolfstetter (Institute of Economic Theory I, Humboldt University at Berlin, Spandauer Str. 1, 10178 Berlin, Germany)
    Abstract: If bidders are uncertain whether the auctioneer sticks to the announced reserve, some bidders respond by strategic non-participation, 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, mechanism design
    JEL: D21 D43 D44 D45
    Date: 2013
  13. By: Budde, Jörg
    Abstract: Earlier studies show that contracts under subjective performance evaluation are dichotomous and punish only worst performance. I show that with limited liability payments need not be binary. More importantly, if the agent earns a rent from limited liability, the optimal contract distinguishes only signals of good news and bad news of the agent’s action.
    Keywords: bonus; monotone likelihood ratio; wage compression
    JEL: D82 M52 M54
    Date: 2013–09
  14. By: Forges, Françoise; Vida, Péter
    Abstract: We show that essentially every communication equilibrium of any finite Bayesian game with two players can be implemented as a strategic form correlated equilibrium of an extended game, in which before choosing actions as in the Bayesian game, the players engage in a possibly fin nitely long (but in equilibrium almost surely fi nite), direct, cheap talk.
    Keywords: Bayesian game; pre-play communication; cheap talk; communication equilibrium; correlated equilibrium; Two Player;
    JEL: C72 D70 C73
    Date: 2013–01
  15. By: Panos Markopoulos (Department of Business and Public Administration, University of Cyprus); Kartik Hosanagar (Department of Operations and Information Management, Wharton School, University of Pennsylvania)
    Abstract: As online information availability for products and services is increasing and as buyers engage in more online search prior to purchase decisions, it is becoming more important for firms to know when to invest to reduce buyer uncertainty. This article argues that today's firms should view product design and investments to reduce buyer uncertainty as an integrated process, which is in turn heavily influenced by how much information buyers can obtain independently, for example, by reading other buyers' reviews or by accessing third party infomediaries. Using a game-theoretic model of a competitive market, we explain how product quality decisions influence future investments to reduce buyer uncertainty, and demonstrate how firms should take this dependency into account to avoid over-investing in quality. We also show that firms, and especially lower quality firms, can free ride on the product information already available in the market, and reduce their own disclosure investments. Finally we show that firms can take further advantage of such ambient information availability to ease the intensity of competition among them, and specifically to reduce their product quality investments.
    Keywords: Buyer uncertainty, information disclosure, product quality, infomediaries
    JEL: C72 D43 D82 D83 L13 L15
    Date: 2013–10
  16. By: Chen, Ying; Eraslan, Hülya
    Abstract: We analyze a three-player legislative bargaining game over an ideological and a distributive decision. Legislators are privately informed about their ideological intensities, i.e., the weight placed on the ideological decision relative to the weight placed on the distributive decision. Communication takes place before a proposal is offered and majority rule voting determines the outcome. We show that it is not possible for all legislators to communicate informatively. In particular, the legislator who is ideologically more distant from the proposer cannot communicate informatively, but the closer legislator may communicate whether he would \compromise "or flight" on ideology. Surprisingly, the proposer may be worse off when bargaining with two legislators (under majority rule) than with one (who has veto power), because competition between the legislators may result in less information conveyed in equilibrium. Despite separable preferences, the proposer is always better off making proposals for the two dimensions together.
    Date: 2013–01–01
  17. By: Tong Wang
    Abstract: Along with the development of cloud computing technology, website owners begin to consider migrating their website from private in-house server to public cloud servers. In this paper, we use a principal-agent model to analyze the underlying economic trade-offs of such migration and then extend it into a dynamic environment. Our results indicate that the trade-off between market information precision and rent extraction affects the decision choice between private server and public cloud in the short run; in the long run, the rent extraction effect diminishes and the demand for public cloud increases. In a long run equilibrium, private servers exist but are constrained to a comparatively low level.
    Date: 2013–06–04
  18. By: Sakai, Mayo (Graduate School of Economics, The University of Tokyo)
    Abstract: In the early 20th century Japan, coal mining firms took an intermediary organization of labor, gdormitory system.h Given traditional technology that required high manual skills unknown to managements, firms relied on the intermediary organization both for screening and monitoring workers. This study focuses on referrers of miners, who took an essential role of signaling in the coal mining industry.
    Keywords: organization of labor; asymmetric information; adverse selection; moral hazard; social networks; employee referrers; employee referrals; intermediary management; coal mining; Japan
    JEL: J20 N35 L22
    Date: 2013–10–30
  19. By: Alexander Karaivanov; Robert M. Townsend
    Abstract: We formulate and solve a range of dynamic models of constrained credit/insurance that allow for moral hazard and limited commitment. We compare them to full insurance and exogenously incomplete financial regimes (autarky, saving only, borrowing and lending in a single asset). We develop computational methods based on mechanism design, linear programming, and maximum likelihood to estimate, compare, and statistically test these alternative dynamic models with financial/information constraints. Our methods can use both cross-sectional and panel data and allow for measurement error and unobserved heterogeneity. We estimate the models using data on Thai households running small businesses from two separate samples. We find that in the rural sample, the exogenously incomplete saving only and borrowing regimes provide the best fit using data on consumption, business assets, investment, and income. Family and other networks help consumption smoothing there, as in a moral hazard constrained regime. In contrast, in urban areas, we find mechanism design financial/information regimes that are decidedly less constrained, with the moral hazard model fitting best combined business and consumption data. We perform numerous robustness checks in both the Thai data and in Monte Carlo simulations and compare our maximum likelihood criterion with results from other metrics and data not used in the estimation. A prototypical counterfactual policy evaluation exercise using the estimation results is also featured.
    JEL: C51 C73 D82 O1
    Date: 2013–11
  20. By: Alejandro Francetich
    Abstract: This paper addresses the problem of sequentially allocating timesensitive goods, or one-period leases on a durable good, among agents who compete through time and learn about the common component of the value of the allocation through experience. I show that efficiency is unattainable, and I identify simple variations of sequential second-price or English auctions that implement the second best and the revenuemaximizing auction. When the units are divisible, I also identify the corresponding auctions that allow for double sourcing.Keywords: Dynamic mechanism design, sequential auctions, interdependent values, multi-dimensional types, winner’s curse, double sourcing JEL Classification Numbers: D82, D86
    Date: 2013
  21. By: Benjamin Moll; Robert M. Townsend; Victor Zhorin
    Abstract: Motivated by evidence from the micro data that the type of financial frictions faced by individuals varies across regions within countries, we develop a general equilibrium framework that encompasses different micro financial underpinnings. We use it to compare the implications of two concrete frictions, limited commitment and moral hazard, and argue that these have potentially very different implications at both the macro and the micro level. Aggregate productivity is depressed in the two regimes but for completely different reasons: under limited commitment capital is misallocated across heterogeneous firms. In contrast, under moral hazard, productivity is endogenously lower at the firm level because entrepreneurs exert suboptimal effort. Occupational choice, productivity and firm size distribution, income and wealth inequality, and the speed of individual transitions also differ markedly. We also present an economy with different frictions in different regions. Such mixture regimes turn out to be different from simple convex combinations of the pure moral hazard and pure limited commitment regimes, and they produce interregional patterns of aggregate income, capital and labor flows and external finance that resemble rural-urban patterns observed in the data.
    JEL: D82 E2 O1
    Date: 2013–11
  22. By: Yang Lu (Hong Kong University of Science and Technology); Wing Suen (The University of Hong Kong); Heng Chen (University of Hong Kong)
    Abstract: We study the role rumors play in revolutions using a global game model. Agents with diverse private information rationally evaluate the informativeness of rumors about the regime strength. Without communication among agents, wild rumors are discounted and agents are generally less responsive to rumors than to trustworthy news. When agents can exchange views on the informativeness of rumors, a rumor against the regime would coordinate a larger mass of attackers than that without communication. The effect of communication can be so large that rumors can have a greater impact on mobilization than does fully trustworthy information.
    Date: 2013
  23. By: Brian K. Chen; Paul J. Gertler; Chuh-Yuh Yang
    Abstract: When physicians own complementary medical service facilities such as clinical laboratories and imaging centers, they gain financially by referring patients to these service entities. This situation creates an incentive for the physician to exploit the consumers’ trust by recommending more services than they would demand under full information. This moral hazard cost, however, may be offset by gains in economies of scope if the complementary services are integrated into the physician’s practice. We assess the extent of moral hazard and economies of scope using data from Taiwan, which introduced a “separating” policy, similar to the Stark Law in the US, that restricts physician ownership of pharmacies unless they are fully integrated into the physician’s practice. We find that physicians who own pharmacies prescribe 7.6% more drugs than those who do not own pharmacies. Overall, we find no evidence of economies of scope from integration in the treatment of patients with acute respiratory infections, diabetes, or hypertension. Overall the separating policy was ineffective at controlling drug costs as a large number of physicians choose to integrate pharmacies into their practices in order to become exempt from the policy.
    JEL: I11 I12 K23 L22
    Date: 2013–11

This nep-cta issue is ©2013 by Simona Fabrizi. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.