nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2015‒03‒05
thirteen papers chosen by
Guillem Roig
University of Melbourne

  1. Dynamic Contracting with Limited Commitment and the Ratchet Effect By Dino Gerardi; Lucas Maestri
  2. Menu Auctions and Influence Games with Private Information By Martimort, David; Stole, Lars
  3. Risk Selection under Public Health Insurance with Opt-out By Sebastian Panthöfer
  4. On Budget Balance of the Dynamic Pivot Mechanism By Kiho Yoon
  5. Incentives, Project Choice, and Dynamic Multitasking By Martin Szydlowski
  6. Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives By DeMarzo, Peter M.; Livdan, Dmitry; Tchistyi, Alexei
  7. Equilibrium Fast Traders By Thierry Foucault; Sophie Moinas; Bruno Biais
  8. Homogenous Contracts for Heterogeneous Agents: Aligning Salesforce Composition and Compensation By Daljord, Oystein; Misra, Sanjog; Nair, Harikesh S.
  9. A Theory of Liquidity and Risk Management Based on the Inalienability of Risky Human Capital By Patrick Bolton; Neng Wang; Jinqiang Yang
  10. The Leverage Ratchet Effect By Admati, Anat R.; DeMarzo, Peter M.; Hellwig, Martin F.; Pfleiderer, Paul
  11. Motivating Consummate Effort By Kreps, David M.
  12. Venture Capital and Knowledge Transfer By Dessi, Roberta; Yin, Nina
  13. Personalized Pricing and Advertising: An Asymmetric Equilibrium Analysis By Anderson, Simon P; Baik, Alicia; Larson, Nathan

  1. By: Dino Gerardi; Lucas Maestri
    Abstract: We study dynamic contracting with adverse selection and limited commitment. A firm (the principal) and a worker (the agent) interact for potentially infinitely many periods. The worker is privately informed about his productivity and the firm can only commit to short-term contracts. The ratchet effect is in place since the firm has the incentive to change the terms of trade and offer more demanding contracts when it learns that the worker is highly productive. As the parties become arbitrarily patient, the equilibrium allocation takes one of two forms. If the prior probability of the worker being productive is low, the firm offers a pooling contract and no information is ever revealed. In contrast, if this prior probability is high, the firm fires the unproductive worker at the very beginning of the relationship.
    Keywords: Dynamic Contracting; Limited Commitment; Ratchet Effect.
    JEL: D80 D82 D86
    Date: 2015
  2. By: Martimort, David; Stole, Lars
    Abstract: We study games in which multiple principals influence the choice of a privately-informed agent by offering action-contingent payments. We characterize the equilibrium allocation set as the maximizers of an endogenous aggregate virtual-surplus program. The aggregate maximand for every equilibrium includes an information-rent margin which captures the confluence of the principals’ rent-extraction motives. We illustrate the economic implications of this novel margin in two applications: a public goods game in which players incentivize a common public good supplier, and a lobbying game between conflicting interest groups who offer contributions to influence a common political decision-maker.
    Keywords: Menu auctions, influence games, common agency, screening contracts, public goods games, lobbying games
    JEL: D82
    Date: 2015–02–23
  3. By: Sebastian Panthöfer
    Abstract: This paper studies risk selection between public and private health insurance when some individuals can purchase private insurance by opting out of otherwise mandatory public insurance. Using a theoretical model, I show that public insurance is adversely selected when insurers and insureds are symmetrically informed about health-related risks, and that selection can be of any type (advantageous or adverse) when insureds have private information about health risks. Drawing on data from the German Socio-Economic Panel, I find that: (1) public insurance is adversely selected under the German public health insurance with opt-out scheme, (2) individuals adversely select public insurance based on self-assessed health and advantageously select public insurance based on risk aversion, and (3) there is evidence of asymmetric information.
    Keywords: Public and private health insurance, Risk selection, Asymmetric information
    JEL: D82 H51 I13 I18
    Date: 2015–02
  4. By: Kiho Yoon (Department of Economics, Korea University, Seoul, Republic of Korea)
    Abstract: We modify the dynamic pivot mechanism of Bergemann and VAalimAaki (Econometrica, 2010) in such a way that lump-sum fees are collected from the players. We show that the modi?ed mechanism satis?es ex-ante budget balance as well as ex-post e¡¾ciency, periodic ex-post incentive compatibility, and periodic ex-post individual rationality, as long as the Markov chain representing the evolution of players' private information is irreducible and aperiodic and players are su¡¾ciently patient. We also show that the diverse preference assumption of Bergemann and VAalimAaki may preclude budget balance.
    Keywords: The dynamic pivot mechanism, dynamic mechanism design, budget balance, VCG mechanism, bilateral bargaining
    JEL: C73 D82
    Date: 2015
  5. By: Martin Szydlowski (University of Minnesota)
    Abstract: I study the optimal choice of investment projects in a continuous-time moral hazard model with multitasking. While in the first best, projects are invariably chosen by the net present value (NPV) criterion, moral hazard introduces a cutoff for project selection which depends on both a project's NPV as well as its risk-return ratio. The cutoff shifts dynamically depending on the past history of shocks, the current firm size, and the agent's continuation value. When the ratio of continuation value to firm size is large, investment projects are chosen more efficiently, and project choice depends more on the NPV and less on the risk-return ratio. The optimal contract can be implemented with an equity stake, bonus payments, as well as a personal account. Interestingly, when the contract features equity only, the project selection criterion resembles a hurdle rate.
    Date: 2014
  6. By: DeMarzo, Peter M. (Stanford University); Livdan, Dmitry (University of CA, Berkeley); Tchistyi, Alexei (University of CA, Berkeley)
    Abstract: We consider optimal incentive contracts when managers can, in addition to shirking or diverting funds, increase short term profits by putting the firm at risk of a low probability "disaster." To avoid such risk-taking, investors must cede additional rents to the manager. In a dynamic context, however, because managerial rents must be reduced following poor performance to prevent shirking, poorly performing managers will take on disaster risk even under an optimal contract. This risk taking can be mitigated if disaster states can be identified ex-post by paying the manager a large bonus if the firm survives. But even in this case, if performance is sufficiently weak the manager will forfeit eligibility for a bonus, and again take on disaster risk. When effort costs are convex, reductions in effort incentives are used to limit risk taking, with a jump to high powered incentives in the gambling region. Our model can explain why suboptimal risk taking can emerge even when investors are fully rational and managers are compensated optimally.
    Date: 2014
  7. By: Thierry Foucault (HEC, Paris); Sophie Moinas (TSE (Toulouse University)); Bruno Biais (Université de Toulouse 1 Capitole)
    Abstract: High-speed market connections and information processing improve financial institutions' ability to seize trading opportunities, which raises gains from trade. They also enable fast traders to process information before slow traders, which generates adverse selection. We first analyze trading equilibria for a given level of investment in fast-trading technology and then endogenize this level. Investments can be strategic substitutes or complements. In the latter case, investment waves can arise, where institutions invest in fast-trading technologies just to keep up with the others. When some traders become fast, it increases adverse selection costs for all, i.e., it generates negative externalities. Therefore equilibrium investment can exceed its welfare maximizing counterpart.
    Date: 2014
  8. By: Daljord, Oystein (Stanford University); Misra, Sanjog (UCLA); Nair, Harikesh S. (Stanford University)
    Abstract: Observed contracts in the real-world are often very simple, partly reflecting the constraints faced by contracting firms in making the contracts more complex. We focus on one such rigidity, the constraints faced by firms in fine-tuning contracts to the full distribution of heterogeneity of its employees. We explore the implication of these restrictions for the provision of incentives within the firm. Our application is to salesforce compensation, in which a firm maintains a salesforce to market its products. Consistent with ubiquitous real-world business practice, we assume the firm is restricted to fully or partially set uniform commissions across its agent pool. We show this implies an interaction between the composition of agent types in the contract and the compensation policy used to motivate them, leading to a "contractual externality" in the firm and generating gains to sorting. This paper explains how this contractual externality arises, discusses a practical approach to endogenize agents and incentives at a firm in its presence, and presents an empirical application to salesforce compensation contracts at a US Fortune 500 company that explores these considerations and assesses the gains from a salesforce architecture that sorts agents into divisions to balance firm-wide incentives. Empirically, we find the restriction to homogenous plans significantly reduces the payoffs of the firm relative to a fully heterogeneous plan when it is unable to optimize the composition of its agents. However, the firm's payoffs come very close to that of the fully heterogeneous plan when it can optimize both composition and compensation. Thus, in our empirical setting, the ability to choose agents mitigates partially the loss in incentives from the restriction to uniform contracts. We conjecture this may hold more broadly.
    Date: 2014–01
  9. By: Patrick Bolton; Neng Wang; Jinqiang Yang
    Abstract: We formulate a dynamic financial contracting problem with risky inalienable human capital. We show that the inalienability of the entrepreneur’s risky human capital not only gives rise to endogenous liquidity limits but also calls for dynamic liquidity and risk management policies via standard securities that firms routinely pursue in practice, such as retained earnings, possible line of credit draw-downs, and hedging via futures and insurance contracts.
    JEL: G3 G32
    Date: 2015–02
  10. By: Admati, Anat R. (Stanford University); DeMarzo, Peter M. (Stanford University); Hellwig, Martin F. (Max Planck Institute for Research on Collective Goods); Pfleiderer, Paul (Stanford University)
    Abstract: Shareholder-creditor conflicts can create leverage ratchet effects, resulting in inefficient capital structures. Once debt is in place, shareholders may inefficiently increase leverage but avoid reducing it no matter how beneficial leverage reduction might be to total firm value. We present conditions for an irrelevance result under which shareholders view asset sales, pure recapitalization and asset expansion with new equity as equally undesirable. We then analyze how seniority, asset heterogeneity, and asymmetric information affect shareholders' choice of leverage-reduction method. Our results are particularly relevant to banking and highlight the benefit and importance of capital regulation to constrain inefficient excessive borrowing.
    Date: 2013–12
  11. By: Kreps, David M. (Stanford University)
    Date: 2014–02
  12. By: Dessi, Roberta; Yin, Nina
    Abstract: This paper explores a new role for venture capitalists, as knowledge intermediaries. A venture capital investor can communicate valuable knowledge to an entrepreneur, facilitating innovation. The venture capitalist can also communicate the entrepreneur's innovative knowledge to other portfolio companies. We study the costs and benefits of these two forms of knowledge transfer, and their implications for investment, innovation, and product market competition. The model also sheds light on the choice between venture capital and other forms of finance, and the determinants of the decision to seek patent protection for innovations. Our analysis provides a rationale for the use of contingencies (specifically, patent approval) in VC contracts documented by Kaplan and Stromberg (2003), and for recent evidence on patterns of syndication among venture capitalists.
    Keywords: venture capital, knowledge intermediaries, contracts, innovation, competition, patents.
    JEL: D82 D86 G24 L22
    Date: 2015–02
  13. By: Anderson, Simon P; Baik, Alicia; Larson, Nathan
    Abstract: We study personalized price competition with costly advertising among n quality-cost differentiated firms. Strategies involve mixing over both prices and whether to advertise. In equilibrium, only the top two firms advertise, earning “Bertrand-like" profits. Welfare losses initially rise then fall with the ad cost, with losses due to excessive advertising and sales by the “wrong " firm. When firms are symmetric, the symmetric equilibrium yields perverse comparative statics and is unstable. Our key results apply when demand is elastic, when ad costs are heterogeneous, and with noise in consumer tastes.
    Keywords: Bertrand equilibrium; consumer targeting; mixed strategy equilibrium; price advertising; price dispersion
    JEL: D43 L13
    Date: 2015–03

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