nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2014‒11‒28
twenty-one papers chosen by
Simona Fabrizi
Massey University

  1. Incentives for Research Agents: Optimal Contracts and Implementation By Yaping Shan
  2. Inequality aversion in long-term contracts By Cato, Susumu; Ebina, Takeshi
  3. Welfare and Optimal Trading Frequency in Dynamic Double Auctions By Songzi Du; Haoxiang Zhu
  4. Turf Wars By Herrera, Helios; Reuben, Ernesto; Ting, Michael M.
  5. Social Insurance, Information Revelation, and Lack of Commitment By Mikhail Golosov; Luigi Iovino
  6. Independent directors: less informed, but better selected? New evidence from a two-way director-firm fixed effect model By Sandra Cavaco; Patricia Crifo; Antoine Rebérioux; Gwenaël Roudaut
  7. The Effect of Communication Channels on Lying By Julian Conrads
  8. Optimal mechanisms for the control of fiscal deficits By Grüner, Hans Peter
  9. Auctions and Leaks: A Theoretical and Experimental Investigation By Sven Fischer; Werner Güth; Todd R. Kaplan; Ro'i Zultan
  10. On the value of randomization By Stéphane Gauthier; Guy Laroque
  11. Private Education Market, Information on Test Scores and Tuition Practices By Firpo, Sergio; Ponczek, Vladimir; Possebom, Vítor Augusto
  12. Masters of the universe: How power and accountability influence self-serving decisions under moral hazard By Marko Pitesa; Stefan Thau
  13. Contagious herding and endogenous network formation in financial networks By Georg, Co-Pierre
  14. The curse of knowledge increases self-selection into competition: Experimental evidence By Danz, David
  15. Access fees for competing lobbies By Martin Gregor
  16. Student Loans and Repayment: Theory, Evidence and Policy By Lochner, Lance; Monge-Naranjo, Alexander
  17. Does a Firm's Exposure to Ethical Issues Matter to Financial Markets? A Governance Perspective By Denis Cormier; Michel Magnan
  18. Essays on Temporary Work Agencies and the Economic Analysis of Law By Westéus, Morgan
  19. The Impatient Salesperson and the Delegation of Pricing Authority By Edward P. Lazear
  20. Shill Bidder’s Behavior in a Second-Price Online Auction By Dominic Herzog
  21. Performance-sensitive debt: The intertwined effects of performance measurement and pricing grid asymmetry By Bannier, Christina E.; Wiemann, Markus

  1. By: Yaping Shan (School of Economics, University of Adelaide)
    Abstract: We study the agency problem between a firm and its research employees. In a multi-agent contracting setting, we show explicitly the way in which the optimal incentive regime is a function of how agents' efforts interact with one another: relative-performance evaluation is used when their efforts are substitutes whereas joint-performance evaluation is used when their efforts are complements. We also provide an implementation of the optimal contract, in which a primary component of the agents' compensation is a risky security. This implementation gives a theoretical justification for the wide-spread use of stock-based compensation by firms that rely on R&D.
    Keywords: Dynamic Contract, Repeated Moral Hazard, Multi-agent Incentive, R&D, Em- ployee Compensation
    JEL: D23 D82 D86 J33 L22 O32
    Date: 2013–11
  2. By: Cato, Susumu; Ebina, Takeshi
    Abstract: This paper examines a two-period moral hazard model with an inequality-averse agent. We show how the agent's past performance will help the principal to relax incentive compatibility constraints and how the existence of an inequality aversion of the agent affects a level of wage in each period in a long-term contract. In particular, we focus on the performance in period 1 on the level of wage in period 2. We show that the agent's wage in period 2 depends on performance in periods 1 and 2. This implies that the long-term relationship creates the opportunity for intertemporal risk and inequality sharing.
    Keywords: Moral hazard, Inequality aversion, Behavioral contract theory, Distribution
    JEL: D63 D86 J31 L23
    Date: 2014–11–14
  3. By: Songzi Du; Haoxiang Zhu
    Abstract: This paper studies the welfare consequence of increasing trading speed in financial markets. We build and solve a dynamic trading model, in which traders receive private information of asset value over time and trade strategically with demand schedules in a sequence of double auctions. A stationary linear equilibrium and its efficiency properties are characterized explicitly in closed form. Slow trading (few double auctions per unit of time) serves as a commitment device that induces aggressive demand schedules, but fast trading allows more immediate reaction to new information. If all traders have the same speed, the socially optimal trading frequency tends to be low for scheduled arrivals of information but high for stochastic arrivals of information. If traders have heterogeneous trading speeds, fast traders prefer the highest feasible trading frequency, whereas slow traders tend to prefer a strictly lower frequency.
    JEL: D44 D82 G14
    Date: 2014–10
  4. By: Herrera, Helios (HEC Montreal); Reuben, Ernesto (Columbia University); Ting, Michael M. (Columbia University)
    Abstract: Turf wars commonly occur in environments where competition undermines collaboration. We develop a game theoretic model and experimental test of turf wars. The model explores how team production incentives ex post affect team formation decisions ex ante. In the game, one agent decides whether to share jurisdiction over a project with other agents. Agents with jurisdiction decide whether to exert effort and receive a reward based on their relative performance. Hence, sharing can increase joint production but introduces competition for the reward. We find that collaboration has a non-monotonic relationship with both productivity and rewards. The laboratory experiment confirms the model's main predictions. We also explore extensions of the basic model, including one where each agent's productivity is private information.
    Keywords: turf war, bureaucracy, jurisdiction, competition, information withholding
    JEL: D73 D74 D82
    Date: 2014–10
  5. By: Mikhail Golosov; Luigi Iovino
    Abstract: We study the optimal provision of insurance against unobservable idiosyncratic shocks in a setting in which a benevolent government cannot commit. A continuum of agents and the government play an infinitely repeated game. Actions of the government are constrained only by the threat of reverting to the worst perfect Bayesian equilibrium (PBE). We construct a recursive problem that characterizes the resource allocation and information revelation on the Pareto frontier of the set of PBE. We prove a version of the Revelation Principle and find an upper bound on the maximum number of messages that are needed to achieve the optimal allocation. Agents play mixed strategies over that message set to limit the amount of information transmitted to the government. The central feature of the optimal contract is that agents who enter the period with low implicitly-promised lifetime utilities reveal no information to the government and receive no insurance against current period shock, while agents with high promised utilities reveal precise information about their current shock and receive insurance as in economies with full commitment by the government.
    JEL: D82 D86 E61 H3
    Date: 2014–10
  6. By: Sandra Cavaco; Patricia Crifo; Antoine Rebérioux; Gwenaël Roudaut
    Abstract: This paper develops a two-way director-firm fixed effect model to study the relationship between independent directors’ individual heterogeneity and firm operating performance, using French data. This strategy allows considering and differentiating in a unified empirical framework mechanisms related to board functioning and mechanisms related to director selection. We first show that the independence status, netted out unobservable individual heterogeneity, is negatively related to performance. This result suggests that independent board members experience a strong informational gap that outweighs other monitoring benefits. However, we show that industry-specific expertise as well as informal connections inside the boardroom may help to bridge this gap. Second, we provide evidence that independent directors have higher intrinsic ability as compared to affiliated board members, consistent with a reputation-based selection process.
    Keywords: independent director heterogeneity, information asymmetry, director selection, firm performance, two-way fixed effect model.
    JEL: G30 G34
    Date: 2014
  7. By: Julian Conrads (University of Cologne)
    Abstract: This paper investigates the effect of different channels of communication on lying behavior. A simple coin flip game with four coin tosses is adapted in which subjects have monetary incentives to misreport their private information. The treatments differ with respect to the communication channel employed to convey the private information, i.e., face-to face, phone, computer-mediated, and online. Against the hypotheses, the results show that a majority of subjects lies independently of communication channel in use. However, the decision whether to lie either to some or the full extent depends on the communication channel. Compared to more socially-distant communication, direct communication encourages partial lying, but decreases lying to the extreme. Women tend to lie to the full extent only under online communication. Social distance considerations and the probability of being detect lying may drive observed behavioral patterns. The findings highlight the relevance of lying costs in relation to the decision making environment.
    Keywords: experiment, private information, lying costs, communication
    JEL: C91 D63 D82 D83
  8. By: Grüner, Hans Peter
    Abstract: This paper shows that a simple two-stage voting mechanism may implement a constrained optimal state dependent decision about a fiscal deficit. I consider a setup with strategic fiscal deficits à la Tabellini and Alesina (1990). Three groups of voters are informed about the productivity of current public spending. Voters differ in their preferences for public goods and swing voters’ preferences may change over time. The current government decides on the current spending mix and it has an incentive to strategically overspend. Under certain conditions, a simple two-stage mechanism in which a deficit requires the approval by a supermajority in parliament implements a constrained optimal decision. When the current majority is small, bargaining between political parties may further increase social welfare. However, when the current majority is large, a supermajority mechanism with bargaining leads to a biased spending mix and reduces welfare whereas the laissez faire mechanism may yield the first best. An appropriately adjusted majority threshold can deal with this problem. JEL Classification: D82, H62
    Keywords: constitutional choice, fiscal policy rules, mechanism design
    Date: 2014–08
  9. By: Sven Fischer (Max Planck Institute of Economics, Jena, and Max Planck Institute for Research on Collective Goods, Bonn); Werner Güth (Max Planck Institute of Economics, Strategic Interaction Group); Todd R. Kaplan (University of Exeter, and University of Haifa); Ro'i Zultan (Ben Gurion University of the Negev)
    Abstract: We study first- and second-price private value auctions with sequential bidding where second movers may discover the first movers bids. There is a unique equilibrium in the first-price auction and multiple equilibria in the second-price auction. Consequently, comparative statics across price rules are equivocal. We experimentally find that in the first-price auction, leaks benefit second movers but harm first movers and sellers. Low to medium probabilities of leak eliminate the usual revenue dominance of first-price over second-price auctions. With a high probability of a leak, second-price auctions generate higher revenue.
    Keywords: auctions, espionage, collusion, laboratory experiments
    JEL: C72 C91 D44
    Date: 2014–11–11
  10. By: Stéphane Gauthier (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris); Guy Laroque (IEP Paris - Sciences Po Paris - Institut d'études politiques de Paris - Institut d'Études Politiques [IEP] - Paris - PRES Sorbonne Paris Cité - Fondation Nationale des Sciences Politiques [FNSP], Department of Economics - University College London)
    Abstract: The paper identifies a necessary and sufficient condition for a deterministic local optimum to be locally improved upon by a stochastic deviation. When this condition is satisfied, a method to construct the stochastic allocations that increase the objective is provided. This technique is applied to a number of adverse selection and moral hazard problems.
    Keywords: second order conditions; constrained optimization; incentive constraints; random contracts
    Date: 2014–05
  11. By: Firpo, Sergio (Sao Paulo School of Economics); Ponczek, Vladimir (Sao Paulo School of Economics); Possebom, Vítor Augusto (Sao Paulo School of Economics)
    Abstract: In this paper, we study the impact of disclosing information about school quality of private schools in Brazil on school choice. Particularly, we investigate whether test score disclosure affected private schools' tuition prices. In 2006, Brazil started to announce the schools' average test score of ENEM, a high school exit exam run by the federal government. Using longitudinal school data, we gauge the effect of test score disclosure on tuitions of private schools for three different schools levels (elementary, middle and high school). We find that the disclosure of schools' average test scores affects tuitions positively for all these three educational levels, but the effect is larger for high school tuitions. We also find that private education markets are local instead of national, since local ranks better predict tuition prices than national ranks. Finally, adjustments on prices did not follow immediately after the publication of scores but occurred gradually over time, revealing that the parents needed some time to trustfully associate results on the exam to new information on school quality.
    Keywords: educational markets, information provision, private schools, tuition practices, school quality
    JEL: O12 I21 L15 D82
    Date: 2014–09
  12. By: Marko Pitesa (GEM - Grenoble Ecole de Management - Grenoble École de Management (GEM)); Stefan Thau (LBS - London Business School - London Business School)
    Abstract: This paper provides an answer to the question of why agents make self-serving decisions under moral hazard and how their self-serving decisions can be kept in check through institutional arrangements. Our theoretical model predicts that the agents' power and the manner in which they are held accountable jointly determine their propensity to make self-serving decisions. We test our theory in the context of financial investment decisions made under moral hazard using others' funds. Across three studies, using different decision-making tasks, different manipulations of power and accountability, and different samples, we show that agents' power makes them more likely to behave in a self-serving manner under moral hazard, but only when the appropriate accountability mechanisms are not in place. Specifically, we distinguish between outcome and procedural accountability and show that holding agents accountable for their decision-making procedure reduces the level of self-serving decisions under moral hazard and also curbs the negative consequences of power. Implications for decisions under moral hazard, the psychology of power, and the accountability literature are discussed.
    Keywords: moral hazard; accountability; power; investment decisions; unethical behavior
    Date: 2013–02–04
  13. By: Georg, Co-Pierre
    Abstract: When banks choose similar investment strategies, the financial system becomes vulnerable to common shocks. Banks decide about their investment strategy ex-ante based on a private belief about the state of the world and a social belief formed from observing the actions of peers. When the social belief is strong and the financial network is fragmented, banks follow their peers and their investment strategies synchronize. This effect is stronger for less informative private signals. For endogenously formed interbank networks, however, less informative signals lead to higher network density and less synchronization. It is shown that the former effect dominates the latter.
    Keywords: social learning,endogenous financial networks,multi-agent simulations,systemic risk
    JEL: G21 C73 D53 D85
    Date: 2014
  14. By: Danz, David
    Abstract: The psychology literature provides ample evidence that people have difficulties taking the perspective of less-informed others. This paper presents a controlled experiment showing that this "curse of knowledge" can cause comparative overconfidence and overentry into competition. In a broader context, the results provide an explanation for the overconfidence of nascent entrepreneurs and the substantial rate of failure among new businesses.
    Keywords: curse of knowledge,hindsight bias,information projection,overconfidence,sorting,incentive schemes,competition,beliefs,experiments
    JEL: C91 D80 D82 D83 D84
    Date: 2014
  15. By: Martin Gregor (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nábreží 6, 111 01 Prague 1, Czech Republic)
    Abstract: We model `money buys access' informational lobbying as a commitment from the policy-maker to observe a lobby's verifiable evidence only upon receiving an access fee. We specifically examine the policy-maker's optimal access fees in the presence of two strictly competing lobbies. Our novel method constructs bargaining surpluses in parallel bilateral bargaining problems in which a negative sign for the bilateral surplus implies a strategic access restriction. This approach easily identifies the equilibrium set of participating lobbies for any information structure and any timing for the lobbies' access. We explain the incomplete participation of lobbies and the resulting information and welfare distortion using the information and revenue complementarities of signals. We also show that a lower bias may be either a blessing or curse for a lobby depending on the information structure and timing. Finally, we demonstrate that promoting lobbying competition may be detrimental to welfare due to the policy-maker's revenue-information tradeoff.
    Keywords: informational lobbying, access fee, persuasion, verifiable evidence
    JEL: C72 C78 D72 D83
    Date: 2014–07
  16. By: Lochner, Lance (University of Western Ontario); Monge-Naranjo, Alexander (Federal Reserve Bank of St. Louis)
    Abstract: In this paper we explore alternative models for insurance and incentives problems and assess them in terms of the implied behavior for human capital investment, consumption and default. We consider models with exogenously specified market incompleteness as well as models in which imperfect insurance arises endogenously from incentive problems. We derived sharp predictions from stylized versions of standard models in the literature. However, we go also beyond existing literature by considering hybrid models, in which combinations of two or three incentives problems are present. We find that all standard models (with only one incentive problem) produce counterfactual implications for either investment and/or for the behavior of default and consumption. Our preferred models because of their implied credit terms (interest rates), investments and default are (1) limited commitment with exogenously non-contingent repayments and (2) moral hazard combined with costly state verification.
    Keywords: Borrowing; Student Loans; Default; Repayment; Income-Contingent; Credit Constraint.
    JEL: H81 I22 I28
    Date: 2014–11–03
  17. By: Denis Cormier (ESG UQAM); Michel Magnan (Concordia University)
    Abstract: This paper investigates if a firm's ethical issues, in conjunction with its governance, affect its standing within financial markets. A firm's ethical reputation arises from its involvement in ethical violations and incidents while a comprehensive index proxies for governance. We assess a firm's standing within financial markets through two complementary perspectives, i.e., the level of information asymmetry between managers and investors as inferred from analyst forecast dispersion and analyst forecast error and the relation between a firm's earnings and its stock market valuation (value relevance). Our results suggest that a firm's ethical reputation affects financial analysts' forecasts as well as the stock market value assigned to its reported earnings. Moreover, it appears that corporate governance moderates such relations, with strong (weak) governance compensating for a weak (strong) ethical reputation. Overall, our evidence shows that ethical issues do not seem to pay.
    Keywords: Corporate governance, ethical issues, information asymmetry, stock markets
    Date: 2014–11
  18. By: Westéus, Morgan (Department of Economics, Umeå School of Business and Economics)
    Abstract: Paper [I] adds to the theoretical literature on the incentives of Temporary Work Agencies (TWAs). Using a principal-agent model with hidden action to model two main types of contracts between a TWA and a Client Firm (CF), the TWA is shown to potentially act against the best interest of the CF when helping to fill a vacant position. The results also suggest that the adverse effect of the incentive misalignment is larger when the worker is going to be leased instead of hired by the CF. However, this effect could potentially be offset by introducing a sufficient level of competition among the TWAs. <p> Paper [II] uses individual-level data on young adults to estimate how the probability of being employed in the Swedish temporary agency sector is affected by whether a partner or other family member has experience of temporary agency work. The results show a significant effect from all peer groups of a magnitude that correspond to the other most influential control variables. We also find that this cohort of the agency sector has a relatively high education level compared to the regular sector, and that there are predominately men working in this sector. <p> Paper [III] analyses possible effects on total employment, and the distribution between agency work and regular contracts as a consequence of the implementation of the EU Temporary and Agency Workers Directive in Sweden. The analysis is based on changes in the compensation to agency workers in a calibrated extension of a Mortensen-Pissarides search model. Even though the results suggest a negative net effect on total employment, the implementation is shown to increase (utilitarian) welfare, and an increased transition probability from the agency sector into regular employment will increase welfare even further. <p> Paper [IV] focuses on settlement probabilities for different types of representation within the Swedish Labour Court. Empirical estimates on a set of unjust dismissal cases show that private representatives are generally less likely to reach a settlement than their union counterparts. The settlement probabilities converge following court-mandated information disclosure, which suggests that information asymmetry is an important factor in explaining differences in settlement behaviour. Privately instigated negotiations are therefore in general insufficient for making cases with non-union representation reach the same settlement rate as cases with union representation.
    Keywords: Temporary work agency; family work experience; young adults; Sweden; labour law; EU directive; unemployment; unjust dismissals; negotiations; settlements; labour unions
    JEL: D81 D82 E24 J12 J21 J41 J42 J44 J48 J52 J64 J82 K31 K41
    Date: 2014–11–12
  19. By: Edward P. Lazear
    Abstract: Sales agents are impatient relative to owners. If a good fails to sell, the owner still retains possession of that good and can enjoy its services, whereas the agent receives nothing. As a consequence, sales agents prefer a lower price than does an owner. Owners are therefore reluctant to delegate pricing authority to sales agents even when the agents have superior market information. Pricing authority is more likely to be delegated to agents when the owner lacks monopoly power and sells competitively and when the good is a non-durable. Agents who are given pricing authority are less likely to be paid commissions and more likely to be on a straight salary.
    JEL: D4 M5
    Date: 2014–09
  20. By: Dominic Herzog (University of Basel)
    Abstract: <span lang="EN-US">Shill bidding is a fraudulent in-auction strategy where a seller participates as a bidder in his own auctions. This is the first paper on shill bidding that is based on a data set which includes personal details. Along with bidding histories, I can prove that on the investigated platform 0.3% of all auctions were influence by obvious shill bidders. The majority of the proven shill bidders' behavior in this paper does not fulfill any of the shill bidder types' criteria discussed in the literature. I adopt two algorithms which aim to identify shill bidders based on public information. On average, these approaches assign a higher probability of being a shill bidder to the accounts of bidders who certainly shilled on auctions in my data set. However, a reliable identification of proven shill bidders and honest bidders is only possible to a limited extent.</span>
    Keywords: auction, shill bidding, bidding behavior
    JEL: D12 D44
    Date: 2014
  21. By: Bannier, Christina E.; Wiemann, Markus
    Abstract: This paper studies the use of performance pricing (PP) provisions in debt contracts and compares accounting-based with rating-based pricing designs. We find that rating-based provisions are used by volatile-growth borrowers and allow for stronger spread increases over the credit period. Accounting-based provisions are employed by opaque-growth borrowers and stipulate stronger spread reductions. Further, a higher spread-increase potential in rating-based contracts lowers the spread at the loan's inception and improves the borrower's performance later on. In contrast, a higher spread-decrease potential in accounting-based contracts lowers the initial spread and raises the borrower's leverage afterwards. The evidence indicates that rating-based contracts are indeed employed for different reasons than accounting-based contracts: the former to signal a borrower's quality, the latter to mitigate investment inefficiencies.
    Keywords: Performance pricing,performance-sensitive debt,accounting data,credit ratings,underinvestment,collateral
    JEL: G30 M40
    Date: 2014

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