nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2015‒02‒28
eleven papers chosen by
Guillem Roig
University of Melbourne

  1. Dynamic Managerial Compensation: On the Optimality of Seniority-based Schemes By Daniel Garrett ; Alessandro Pavan
  2. Information, Risk Sharing and Incentives in Agency Problems By Jia xie
  3. Dynamic Moral Hazard without Commitment By Johannes Horner ; Larry Samuelson
  4. Dynamic Mechanisms without Money By Yingni Guo ; Johannes Horner
  5. Why organizations fail: models and cases By Garicano, Luis ; Rayo, Luis
  6. Competing Teams By Hector Chade
  7. The International Transmission of Credit Bubbles: Theory and Policy By Jaume Ventura ; Alberto Martin
  8. Wealth Distribution and Human Capital: How Borrowing Constraints Shape Educational Systems By Marti Mestieri
  9. Frustration and Anger in Games By Pierpaolo Battigalli ; Martin Dufwenberg ; Alec Smith
  10. The Safety Trap By Ricardo J Caballero ; Emmanuel Farhi
  11. Voting on Prices vs. Voting on Quantities in a World Climate Assembly By Martin L. Weitzman

  1. By: Daniel Garrett ; Alessandro Pavan
    Abstract: We study the optimal dynamics of incentives for a manager whose ability to generate cash ows changes stochastically with time and is his private information. We show that, in general, the power of incentives (or "pay for performance") may either increase or decrease with tenure. However, risk aversion and high persistence of ability call for a reduction in the power of incentives later in the relationship. Our results follow from a new variational approach that permits us to tackle directly the "full program," thus bypassing some of the di¢ culties of working with the "relaxed program" encountered in the dynamic mechanism design literature.
    Keywords: managerial compensation, power of incentives, pay for performance, dynamic mechanism design, adverse selection, moral hazard, persistent productivity shocks, risk aversion. JEL Classification: D82
    Date: 2014–11–01
  2. By: Jia xie
    Abstract: This paper studies the use of information for incentives and risk sharing in agency problems. When the principal is risk neutral or the outcome is contractible, risk sharing is unnecessary or completely taken care of by a contract on the outcome. In this case, information systems are ranked according to their informativeness of the agent’s action. When the outcome is noncontractible, however, the principal has to rely on imperfect information for both incentives and risk sharing. Under the first-order approach, we characterize a problem-independent ranking of information systems, which is relaxed from Gjesdal’s (1982) criterion. We also find sufficient conditions justifying the firstorder approach.
    Keywords: Economic models
    JEL: D8
    Date: 2015
  3. By: Johannes Horner (Cowles Foundation, Yale University ); Larry Samuelson (Cowles Foundation, Yale University )
    Abstract: We study a discrete-time model of repeated moral hazard without commitment. In every period, a principal finances a project, choosing the scale of the project and a contingent payment plan for an agent, who has the opportunity to appropriate the returns of a successful project unbeknownst the principal. The absence of commitment is reflected both in the solution concept (perfect Bayesian equilibrium) and in the ability of the principal to freely revise the project's scale from one period to the next. We show that removing commitment from the equilibrium concept is relatively innocuous -- if the players are sufficiently patient, there are equilibria with payoffs low enough to effectively endow the players with the requisite commitment, within the confines of perfect Bayesian equilibrium. In contrast, the frictionless choice of scale has a significant effect on the project's dynamics. Starting from the principal's favorite equilibrium, the optimal contract eventually converges to the repetition of the stage-game Nash equilibrium, operating the project at maximum scale and compensating the agent (only) via immediate payments.
    Keywords: Moral hazard, Dynamic moral hazard, Commitment, Principal-agent, Cash flow diversion
    JEL: C72 D82 D86
    Date: 2015–02
  4. By: Yingni Guo (Dept. of Economics, Northwestern University ); Johannes Horner (Cowles Foundation, Yale University )
    Abstract: We analyze the optimal design of dynamic mechanisms in the absence of transfers. The designer uses future allocation decisions as a way of eliciting private information. Values evolve according to a two-state Markov chain. We solve for the optimal allocation rule, which admits a simple implementation. Unlike with transfers, efficiency decreases over time, and both immiseration and its polar opposite are possible long-run outcomes. Considering the limiting environment in which time is continuous, we show that persistence hurts.
    Keywords: Mechanism design, Principal-Agent, Token mechanisms
    JEL: C73 D82
    Date: 2015–02
  5. By: Garicano, Luis ; Rayo, Luis
    Abstract: Organizations fail due to incentive problems (agents do not want to act in the organization's interests) and bounded rationality problems (agents do not have the necessary information to do so). This survey uses recent advances in organizational economics to illuminate organizational failures along these two dimensions. We combine reviews of the literature with simple models and case discussions. Specifically, we consider failures related to the allocation of authority and short-termism, both of which are instances of 'multitasking problems'; communication failures in the presence of both soft and hard information due to incentive misalignments; resistance to change due to vested interests and rigid cultures; and failures related to the allocation of talent and miscommunication due to bounded rationality. We find that the organizational economics literature provides parsimonious explanations for a large range of economically significant failures.
    Keywords: organizational economics
    JEL: D21 D86 J33 L23 M52
    Date: 2015–02
  6. By: Hector Chade (arizona state university )
    Abstract: In many economic environments, firms compete in output markets that are not competitive, either because there is strategic interaction such as in a patent race or an oligopoly, or there are externalities such as knowledge spillovers. Very often, having skilled workers is crucial for success in these non-competitive markets. The key question in the presence of market failure is how and when the market allocation of workers to teams differs from the socially optimal allocation. Is it optimal to have the best workers together in superstar teams competing against low skilled teams, or is it better to have competition between balanced teams? Under what circumstances is the market allocation efficient? This has far-reaching implications for the optimal design of markets, ranging from research to sports competitions.
    Date: 2014
  7. By: Jaume Ventura ; Alberto Martin
    Abstract: We live in a new world economy characterized by financial globalization and historically low interest rates. This environment is conducive to countries experiencing credit bubbles that have large macroeconomic effects at home and are quickly propagated abroad. In previous work, we built on the theory of rational bubbles to develop a framework to think about the origins and domestic effects of these credit bubbles. This paper extends that framework to two-country setting and studies the channels through which credit bubbles are transmitted across countries. We find that there are two main channels that work through the interest rate and the terms of trade. The former constitutes a negative spillover, while the latter constitutes a negative spillover in the short run but a positive one in the long run. We study both cooperative and noncooperative policies in this world. The interest-rate and terms-of-trade spillovers produce policy externalities that make the noncooperative outcome suboptimal.
    JEL: E32 E44 O40
    Date: 2015–02
  8. By: Marti Mestieri (Toulouse School of Economics )
    Abstract: This paper provides a theory of how the wealth distribution of an economy affects the optimal design of its educational system. The model features two key ingredients. First, agents are heterogeneous both in their ability and we alth levels, neither of which is observable. Second, returns to schooling depend on the ability-composition of agents attending each school tier, for example, because of choices of common curricula. An educational system is characterized by an assignment rule of agents to schools and by endogenous sizes of tiers. I find that a benevolent planner seeking to maximize economic efficiency implements "elitist" educational systems in economies with poor, borrowing-constrained, agents. Compared to the first best, the optimal solution features (i) relatively low-ability, rich agents selecting into higher education and (ii) higher education schools with less capacity. The same qualitative results obtain when only two commonly used instruments are available to the planner: school fees and exams. In addition, I show that economies with relatively tighter borrowing constraints rely more extensively on exams and that agents performing better on exams are rewarded with lower school fees.
    Date: 2014
  9. By: Pierpaolo Battigalli ; Martin Dufwenberg ; Alec Smith
    Abstract: Frustration, anger, and aggression have important consequences for economic and social behavior, concerning for example monopoly pricing, contracting, bargaining, tra¢ c safety, violence, and politics. Drawing on insights from psychology, we develop a formal approach to exploring how frustration and anger, via blame and aggression, shape interaction and outcomes in economic settings. KEYWORDS: frustration, anger, blame, belief-dependent preferences, psychological games JEL codes: C72, D03
    Date: 2015
  10. By: Ricardo J Caballero ; Emmanuel Farhi
    Abstract: In this paper we provide a model of the macroeconomic consequences of a shortage of safe assets. In particular, we discuss the emergence of a deflationary safety trap equilibrium which is an acute form of a liquidity trap. Issuing public debt, swapping private risky assets for public debt, or increasing the inflation target, stimulate ag- gregate demand and output in a safety trap. Instead, forward guidance is ineffective. The safety trap can be arbitrarily persistent, as in the secular stagnation hypothesis,despite the existence of infinitely lived assets.
    Date: 2015–01
  11. By: Martin L. Weitzman
    Abstract: This paper posits the conceptually useful allegory of a futuristic "World Climate Assembly" that votes on global carbon emissions via the basic principle of majority rule. Two variants are considered. One is to vote on a universal price (or tax) that is internationally harmonized, but the proceeds from which are domestically retained. The other is to vote on the overall quantity of total worldwide emissions, which are then distributed for free (via a pre-decided fractional subdivision formula) as individual allowance permits that are subsequently marketed in an international cap-and-trade system. The model of the paper suggests that the majority-voted price is likely to be less distortionary and easier to enact than the majority-voted total quantity of permits. While the study is centered on a formal model, the tone of the policy discussion resembles more an exploratory think piece.
    JEL: F51 H41 Q54
    Date: 2015–02

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