nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2015‒02‒16
eight papers chosen by
Guillem Roig
University of Melbourne

  1. Honesty and Relational Contracts By Schmutzler, Armin; Holger, Herz; André, Volk
  2. Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion By Herweg, Fabian; Karle, Heiko; Müller, Daniel
  3. Financial Contracting with Tax Evaders By Meyer-Brauns, Philipp
  4. Loss Aversion and Inefficient Renegotiation By Schmidt, Klaus; Herweg, Fabian
  5. Bailouts and Prudential Policies - A Delicate Interaction By Ernesto Pastén
  6. Constrained Inefficiency and Optimal Taxation with Uninsurable Risks By Piero Gottardi; Atsushi Kajii; Tomoyuki Nakajima
  7. Household bargaining and the design of couples' income taxation By Roeder, Kerstin; Cremer, Helmuth; Lozachmeur, Jean-Marie; Maldonado, Dario
  8. An optimal incentive contract to avert firm relocation By Pollrich, Martin; Schmidt, Robert

  1. By: Schmutzler, Armin; Holger, Herz; André, Volk
    Abstract: We study the economic consequences of opportunities for dishonesty in an environment where efficiency relevant behaviour is not contractible, but rather incentivized by informal agreements in an ongoing relationship. We document the repeated interaction between a principal and an agent who, within our main treatment, was privately informed about the costs of effort provision being either high or low. At the beginning of the interaction, an agent could either truthfully report the cost type to the principal or choose to lie about it. We find that a substantial fraction of low cost agents decided to signal high costs. Dishonest low cost and honest high cost agents pool on the complete information outcome with high costs, as measured in our control treatment. The outcome of such pooling is less efficient than for honest low cost agents. Moreover, principals who face dishonest agents earn substantially less profits than those facing honest agents. Our evidence therefore suggests that informal agreements in a repeated interaction generate less efficient outcomes if dishonesty is possible but, at the same time, are robust to substantial degrees of deception. We furthermore show that our experimental findings can be organized using the logic of repeated games.
    JEL: C73 D23 D82
    Date: 2014
  2. By: Herweg, Fabian; Karle, Heiko; Müller, Daniel
    Abstract: We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer's expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer's expectation management, our theory provides a rationale for ``employment contracts'' in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.
    JEL: C78 D82 D03
    Date: 2014
  3. By: Meyer-Brauns, Philipp
    Abstract: This paper derives the optimal financial contract when a borrowing entrepreneur can evade taxes in a model of costly state verification. In contrast to previous literature on costly state verification and financial contracting, we find that standard debt contracts are not optimal when tax evasion is possible. Instead, the optimal contract is debt-like only for very low and very high profit realizations, and features a constant repayment and verification of returns in an intermediate range. This occurs because the entrepreneur has to be given a positive rent even under verification in order to not abuse her limited liability protection for excessive tax evasion activities.
    JEL: G30 H26 D82
    Date: 2014
  4. By: Schmidt, Klaus; Herweg, Fabian
    Abstract: We propose a theory of inefficient renegotiation that is based on loss aversion. When two parties write a long-term contract that has to be renegoti- ated after the realization of the state of the world, they take the initial contract as a reference point to which they compare gains and losses of the renegotiated transaction. We show that loss aversion makes the renegotiated outcome sticky and materially inefficient. The theory has important implications for the optimal design of long-term contracts. First, it explains why parties often abstain from writing a beneficial long-term contract or why some contracts specify transactions that are never ex post efficient. Second, it shows under what conditions parties should rely on the allocation of ownership rights to protect relationship-specific investments rather than writing a specific performance contract. Third, it shows that employment contracts can be strictly optimal even if parties are free to rene- gotiate.
    JEL: C78 D03 D86
    Date: 2014
  5. By: Ernesto Pastén
    Abstract: Could prudential policies backfire by making the lack of commitment problem of bailouts worse? This commitment problem refers to the excessive risk taken by banks and financial institutions in expectations of bailouts if crises occur, which in turn increase financial fragility and the severity of crises. Ex-ante policies, such as prudential policies, have a variety of effects on the various components of the ex-post incentives of an authority to implementing a bailout. Thus, the interaction between prudential policies and bailouts is delicate: In different conditions, a given prudential policy may backfire or increase its effectiveness by worsening or alleviating the lack of commitment problem of bailouts. Liquidity requirements and prudential taxes are examples of prudential policies that may backfire. Public debt is an example of an ex-ante policy usually with no prudential motivation that may play such a role.
    Date: 2014–12
  6. By: Piero Gottardi (European University Institute and Universita Ca' Foscari, Venice); Atsushi Kajii (Kyoto University and Singapore Management University); Tomoyuki Nakajima (Kyoto University and CIGS)
    Abstract: When individuals' labor and capital income are subject to uninsurable idiosyncratic risks, should capital and labor be taxed, and if so how? In a two period general equilibrium model with production, we derive a decomposition formula of the welfare effects of these taxes into insurance and distribution effects. This allows us to determine how the sign of the optimal taxes on capital and labor depend on the nature of the shocks, the degree of heterogeneity among consumers' income as well as on the way in which the tax revenue is used to provide lump sum transfers to consumers. When shocks affect primarily labor income and heterogeneity is small, the optimal tax on capital is positive. However in other cases a negative tax on capital is welfare improving.
    Keywords: optimal linear taxes, incomplete markets, constrained efficiency
    JEL: D52 H21
    Date: 2015–02
  7. By: Roeder, Kerstin; Cremer, Helmuth; Lozachmeur, Jean-Marie; Maldonado, Dario
    Abstract: The paper studies the design of couples income taxation when consumption and labor supply decisions within the couple are made in a cooperative way according to some bargaining scheme. Specifically, the couple maximizes a weighted sum of the spouses utilities. In the first part of the paper, the spouses bargaining weights (specific to each couple) are exogenously given. In the second part, these bargaining weights are endogenous, and depend on the spouses respective contributions to total family income. The information structure is the traditional one in Mirrleesian nonlinear income tax models. However, while the household s total consumption is publicly observable, the consumption levels of the individual spouses are not observable. The social welfare function is utilitarian. We show that the expression for a spouses marginal income tax rate includes a Pigouvian (paternalistic) and an incentive term. With exogenous weights the Pigouvian term favors a marginal subsidy (tax) for the high-weight (lowweight) spouse, whose labor supply otherwise tends to be too low (high). In some cases both terms have the same sign and imply a positive marginal tax for the low-weight spouse and a negative one for the high-weight spouse.
    JEL: H21 H31 D10
    Date: 2014
  8. By: Pollrich, Martin; Schmidt, Robert
    Abstract: In a globalized economy, firms move production to other countries without turning a hair. A local policy maker who seeks to avert relocation faces a dynamic problem - incentivizing the firm to remain in its home country today does not guarantee that the firm also stays in the future. We investigate situations where contracts between a local regulator and the firm can be written on some contractible productive activity, e.g. labor, output, or the firm's emissions. The firm undertakes a location-specific investment that is not contractible. When long-term contracts are feasible, the regulator averts relocation by postponing a sufficient amount of transfer to the second period. With limited commitment, i.e. when only short-term contracts are feasible, contracts with positive transfers in the second period cannot be implemented if the firm's investment is unobservable to the regulator. The regulator can avoid this problem by a tighter regulation in the first period. This induces the firm to invest more, which creates a `lock-in effect' that prevents relocation without transfers in period 2. An important application of our model is in the area of climate policy, where firm relocation can be triggered via a unilateral introduction of an emissions price by a country.
    JEL: D82 D86 L51
    Date: 2014

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