nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2014‒11‒17
fourteen papers chosen by
Simona Fabrizi
Massey University

  1. Corruption in PPPs, Incentives and Contract Incompleteness By Elisabetta Iossa; David Martimort
  2. How public information affects asymmetrically informed lenders: evidence from credit registry reform By Choudhary, M. Ali; Jain, Anil
  3. Should We Pay for Ecosystem Service Outputs, Actions or Both? By Ben White; Nick Hanley
  4. Endogenous Growth and Research Activity under Private Information By Oscar Mauricio Valencia
  5. Optimal Sourcing Orders under Supply Disruptions and the Strategic Use of Buffer Suppliers By Sarah Parlane; Ying-Yi Tsai
  6. Incentive compensation for risk managers when effort is unobservable By Paul H. Kupiec
  7. The Appeals Process and Incentives to Settle By Wohlschlegel, Ansgar
  8. The Signaling Role of Note Being Promoted: Theory and Evidence By Jin, Xin
  9. Signaling with Audits: Mimicry, Wasteful Expenditures, and Non-compliance in a Model of Tax Enforcement By Kotowski, Maciej H.; Weisbach, David A.; Zeckhauser, Richard J.
  10. When a Price is Enough: Implementation in Optimal Tax Design By Renes, Sander; Zoutman, Floris T.
  11. Regulatory Intensity, Crash Risk, and the Business Cycle By Xuan Tam; Eric Young; bo sun
  12. Optimal Dynamic Contracts in Financial Intermediation: With an Application to Venture Capital Financing By Igor Salitskiy
  13. Bank Capital Requirements and Mandatory Deferral of Compensation By Feess, Eberhard; Wohlschlegel, Ansgar
  14. The Role of Managerial Work in Market Performance: A Monopoly Model with Team Production By Hildenbrand, Andreas; Duran, Mihael

  1. By: Elisabetta Iossa; David Martimort
    Abstract: In a public procurement setting, we discuss the desirability of completing contracts with state-contingent clauses providing for monetary compensations to the contractor when revenue shocks occur. Realized shocks are private information of the contractor and this creates agency costs of delegated service provision. Verifying the contractor’s messages on the shocks entails contracting costs that make incomplete contracts attractive, despite their higher agency costs. A public official (supervisor) has private information on contracting costs and chooses the degree of contractual incompleteness on behalf of an upper-tier public authority. As the public official may be biased towards the contractor, delegating the contractual choice to that lower-tier may result in incomplete contracts being chosen too often. Empirical predictions on the use of incomplete contracts and policy implications on the benefits of standardized contract terms are discussed.
    Keywords: Corruption, Incomplete Contracts, Moral Hazard, Principal-Agent-Supervisor Model, Public-Private Partnerships, Risk Allocation
    JEL: D23 D82 K42 L33
    Date: 2014
  2. By: Choudhary, M. Ali; Jain, Anil
    Abstract: We exploit exogenous variation in the amount of public information available to banks about a firm to empirically evaluate the importance of adverse selection in the credit market. A 2006 reform introduced by the State Bank of Pakistan (SBP) reduced the amount of public information available to Pakistani banks about a firm’s creditworthiness. Prior to 2006, the SBP published credit information not only about the firm in question but also (aggregate) credit information about the firm’s group (where the group was defined as the set of all firms that shared one or more director with the firm in question). After the reform, the SBP stopped providing the aggregate group-level information. We propose a model with differentially informed banks and adverse selection, which generates predictions on how this reform is expected to affect a bank’s willingness to lend. The model predicts that adverse selection leads less informed banks to reduce lending compared to more informed banks. We construct a measure for the amount of information each lender has about a firm’s group using the set of firm-bank lending pairs prior to the reform. We empirically show those banks with private information about a firm lent relatively more to that firm than other, less-informed banks following the reform. Remarkably, this reduction in lending by less informed banks is true even for banks that had a pre-existing relationship with the firm, suggesting that the strength of prior relationships does not eliminate the problem of imperfect information.
    Keywords: Credit Markets; Asymmetric Information; Credit Registry; Developing Country
    JEL: D8 D82 G14 G18
    Date: 2014–01
  3. By: Ben White (University of Western Australia); Nick Hanley (School of Geography and Sustainable Development, University of St. Andrews)
    Abstract: Payments for ecosystem service outputs have become a popular policy prescription for a range of agri-environmental schemes. The focus of this paper is on the choice of sets of instruments in an ecosystem service principal-agent model that addresses adverse selection and moral-hazard. Results show that input-based and output-based contracts are equivalent where there is full information. With missing information, input-based contracts are more efficient at reducing the informational rent related to adverse selection than output-based contracts. There is an efficiency gain related to using mixed contracts especially where one input is not observable. These contracts allow the regulator to target variables that are costly-to-fake as opposed to those prone to moral hazard such as labour inputs. We then consider the implications of moral hazard and dynamic contracting. An overall finding is that in designing agri-environmental schemes, it is critical that the regulator has an understanding of the link between actions and ecosystem service outputs and, ideally, an estimate of their economic value. Without these in place, payment for ecosystem service schemes will be inefficient and poorly targeted.
    Keywords: payments for ecosystem services, principal-agent models, moral hazard, adverse selection, mechanism design
    JEL: D82 Q24 Q57 Q58
    Date: 2014–10
  4. By: Oscar Mauricio Valencia
    Abstract: This paper examines an endogenous growth model with occupational choice in which innovators produce ideas. Each innovator has private knowledge of their production costs. Developers offer innovators non-linear contract schemes that affect the number of active innovators and the economic growth rate. Two main results are obtained. First, the equilibrium contract under asymmetric information leads to the selection of highly-talented workers in R&D activities and higher profits for developers. Second, the efficiency-rent extraction tradeoff lowers the economic growth rate with respect to the full information case.
    Keywords: Adverse Selection, Innovation, Endogenous Growth.
    JEL: D82
    Date: 2014–09–15
  5. By: Sarah Parlane (University College Dublin); Ying-Yi Tsai (National University of Kaohsiung)
    Abstract: This paper analyses procurement from two, risk-averse, suppliers who are responsible for the timely delivery of some inputs. Their production is subject to inherent disruptions. We characterize the optimal contracts when suppliers can invest to lower the risk of delays that are costly to the manufacturer. When investment is contractible, we show that issuing asymmetric contracts, whereby the buyer is more heavily dependent on one supplier, is optimal as the cost associated with supply disruptions increases. When investment is not contractible, we show that large orders can be used as an incentive devise. Thus, the strategy consisting of selecting one supplier as a main producer and another as a buffer has further desirable advantages under moral hazard.
    Keywords: Investment, Risk, Costly Delays, Order Size and Moral Hazard
    JEL: D23 D86 L24
    Date: 2014–10–21
  6. By: Paul H. Kupiec (American Enterprise Institute)
    Abstract: In a financial intermediary, risk managers can expend effort to reduce loan probability of default and loss given default, but effort is unobservable. Incentive compensation (IC) can induce manager effort. When deposit insurance is subsidized, the demand for risk management declines. Regulatory policy should then reinforce incentives to offer risk mangers appropriate IC contracts.
    Keywords: AEI Economic Policy Working Paper Series, Financial services
    JEL: G
    Date: 2013–10
  7. By: Wohlschlegel, Ansgar
    Abstract: This paper analyzes asymmetrically informed litigants' incentives to settle when they anticipate the possibility of appeals. It identifies a strategic effect, which induces a litigant to negotiate pretrial so as to optimize her posttrial bargaining position, and an information effect, which means that litigants will take into account pretrial how the information revealed by the trial court's verdict will translate into posttrial equilibrium payoffs. The paper's main contribution is twofold: First, it establishes a workhorse model of settlement and litigation in the shadow of appeals which may be used in future research to analyze specific issues of litigation and legal reform. Second, the importance of including the possibility of appeals in the litigation model is highlighted by an example in which some results contradict the immediate intuition: It is shown that (i) more accurate trial courts may actually attract less cases and (ii) cases may go to trial court with a larger ex-ante probability for higher legal costs in the appeals stage.
    Keywords: Litigation; settlement; appeals; sequential bargaining; asymmetric information
    JEL: D82 K41
    Date: 2014–02–14
  8. By: Jin, Xin
    Abstract: This article studies the negative signals associated with non-promotion. I first show theoretically that, when workers’ productivity rises little with additional years on the same job level, the negative signal associated with non-promotion leads to wage decreases. On the other hand, when additional job-level tenure leads to a sizable increase in productivity, workers’ wages increase. I test my model’s predictions using the personnel records from a large US firm from 1970-1988. I find a clear hump-shaped wage-job-tenure profile for workers who stay in the same job level, which supports my model’s prediction.
    Keywords: Asymmetric information, human capital accumulation, signaling, promotion, wages
    JEL: J24 J31 M51
    Date: 2014
  9. By: Kotowski, Maciej H. (Harvard University); Weisbach, David A. (University of Chicago); Zeckhauser, Richard J. (Harvard University)
    Abstract: The audit policy of a tax authority can signal its audit effectiveness. We model this process and show that in limited circumstances an ineffective authority can masquerade as being effective. We show that high maximal penalties imply underreporting of income.
    JEL: C71 D82 D86
    Date: 2014–01
  10. By: Renes, Sander (University of Mannheim); Zoutman, Floris T. (Dept. of Business and Management Science, Norwegian School of Economics)
    Abstract: This paper studies the design of tax systems that implement a planner's secondbest allocation in a market economy. An example shows that the widely used Mirrleesian (1976) tax system cannot implement all incentive-compatible allocations. Hammond's (1979) "principle of taxation" proves that any incentive-compatible allocation can be implemented through at least one tax system. However, this tax system is often undesirable since it severely restricts the choice space of agents in the economy. In this paper we derive necessary and sufficient conditions to verify whether a given tax system can implement a given incentive-compatible allocation. We show that when an incentive-compatible allocation is on the Pareto frontier, and/or surjective onto the choice space, a tax system that equates the marginal tax rates to the optimal wedges can implement the second best, without restricting the choice space of the agents. It follows that the Mirrleesian tax system can successfully implement the second best in the identified classes. Since the secondbest allocation of welfarist planners is always on the Pareto frontier, our results (ex post) validate most tax systems proposed in the literature. Outside of the identified classes, the planner may need to restrict the choice space of agents to implement its second best in the market. This sheds new light on rules, quotas and prohibitions used in real-world tax and benefit systems.
    Keywords: Optimal non-linear taxation; redistribution; tax system; market implementation; price mechanism; private information
    JEL: D82 H21 H22 H24
    Date: 2014–09–24
  11. By: Xuan Tam (Cambridge University); Eric Young (University of Virginia); bo sun (GSM, Peking University)
    Abstract: Regulatory investigations affect information in financial markets through two channels: (i) investigations detect financial manipulation and reveal hidden negative information;(ii) regulatory investigations impose adverse consequences for executives involved in manipulation and deter managerial incentives to manipulate ex ante. Moreover, regulatory intensity varies over time, depending on the aggregate state of the economy. We propose a model to study the implications of cyclical regulatory intensity for stock market dynamics, and show that countercyclicality in financial regulation can lead to countercyclicality in crash risk in the stock markets. We also provide evidence that a strong relation between stock crash risk and the business cycle exists in the data. In addition, our model illustrates a unifying mechanism that contributes to a number of stylized facts including gradual booms and sudden crashes in the financial markets, increased crash risk, and countercyclical stock volatility.
    Date: 2014
  12. By: Igor Salitskiy (Stanford University)
    Abstract: This paper extends the costly state verification model from Townsend (1979) to a dynamic and hierarchical setting with an investor, a financial intermediary, and an entrepreneur. Such a hierarchy is natural in a setting where the intermediary has special monitoring skills. This setting yields a theory of seniority and dynamic control: it explains why investors are usually given the highest priority on projects' assets, financial intermediaries have middle priority and entrepreneurs have the lowest priority; it also explains why more cash flow and control rights are allocated to financial intermediaries if a project's performance is bad and to entrepreneurs if it is good. I show that the optimal contracts can be replicated with debt and equity. If the project requires a series of investments until it can be sold to outsiders, the entrepreneur sells preferred stock (a combination of debt and equity) each time additional financing is needed. If the project generates a series of positive payoffs, the entrepreneur sells a combination of short-term and long-term debt.
    Date: 2014
  13. By: Feess, Eberhard; Wohlschlegel, Ansgar
    Abstract: Tighter capital requirements and mandatory deferral of compensation are among the most prominently advocated regulatory measures to reduce excessive risk-taking in the banking industry. We analyze the interplay of the two instruments in an economy with two heterogenous banks that can fund uncorrelated projects with fully diversifiable risk or correlated projects with systemic risk. If both project types are in abundant supply, we find that full mandatory deferral of compensation is beneficial as it allows for weaker capital requirements, and hence for a larger banking sector, without increasing the incentives for risk-shifting. With competition for uncorrelated projects, however, deferred compensation may misallocate correlated projects to the bank which is inferior in managing risks. Our findings challenge the current tendency to impose stricter regulations on more sophisticated institutes.
    Keywords: Bank capital requirements; deferred bonuses; risk-shifting; financial crisis; executive compensation
    JEL: D62 G21 G28 J33
    Date: 2014–07–23
  14. By: Hildenbrand, Andreas; Duran, Mihael
    Abstract: A monopolist is treated as a nexus of contracts with team production. It has one owner-manager who is the employer of two employees. A team production problem is present if the employer is a “managerial lemon.†If the team production problem is solved, the employer is a “managerial hotshot.†Both managerial hotshot and managerial lemon are found to make profit. Therefore, managerial slack can exist in our monopoly market. Whereas the employer has the incentive to improve management capability in principle, the employees have the incentive to keep management capability low. Moreover, the cost of improving management capability may be prohibitively high. Consequently, managerial slack can persist. The predicted behavior of the monopolist contradicts the neoclassical prediction of market performance in both cases.
    Keywords: firm organization; market structure; property rights
    JEL: C7 D2 D4 L1 L2
    Date: 2014–09–15

This nep-cta issue is ©2014 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.