nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2015‒03‒22
fourteen papers chosen by
Guillem Roig
University of Melbourne

  1. Endogenous favouritism with status incentives: A model of optimum inefficiency By Dey, Oindrila; Banerjee, Swapnendu
  2. Dynamic Mechanisms without Money By Guo, Yingni; Hörner, Johannes
  3. Too Many to Fail - How Bonus Taxation Prevents Gambling for Bailouts By Michael Hilmer
  4. Optimal dynamic procurement contracts with monitoring and lumpy investment By Andreas Asseyer
  5. The Implementation Duality By Noldeke, Georg; Larry Samuelson
  6. Tenure-Track Contract Helps Self-Selection By Popov, Sergey V
  7. The Expected Externality Mechanism in a Level-k Environment By Olga Gorelkina
  8. Uncertain Rationality and Robustness in Games with Incomplete Information By Fabrizio Germano; Peio Zuazo-Garin
  9. Long-term Relationships: Static Gains and Dynamic Inefficiencies By Hemous, David; Olsen, Morten
  10. The Principal-Agent Problem With Time Inconsistent Utility Functions By Boualem Djehiche; Peter Helgesson
  11. Memory, Attention and Choice By Pedro Bordalo; Nicola Gennaioli; Andrei Shleifer
  12. Providing Efficient Incentives to Work: Retirement Ages and the Pension System. By Maxim Troshkin; Ali Shourideh
  13. Buying Locally By George J. Mailath; Andrew Postlewaite; Larry Samuelson
  14. Crash Risk in Currency Markets By Emmanuel Farhi; Samuel Fraiberger; Xavier Gabaix; Romain Ranciere; Adrien Verdelhan

  1. By: Dey, Oindrila; Banerjee, Swapnendu
    Abstract: The paper identifies conditions under which ‘inefficient’ favouritism emerges as an optimal outcome even when the principal do not exhibit ex-ante preferential bias for any particular agent. We characterize how the optimal incentive scheme is influenced in the presence of status incentives. Using a moral hazard framework with limited liability in a multi-agent framework, it is shown that in presence of higher valuation for status incentive inefficient favouritism is more likely to dominate over fairness. Moreover, inefficient favouritism emerges as the optimal outcome when revenue of the firm is sufficient low.
    Keywords: Favouritism, status-incentives, principal-agent, moral hazard, optimal contract
    JEL: D86 L14 L20
    Date: 2015–03–13
  2. By: Guo, Yingni (Northwestern University); Hörner, Johannes (Yale University)
    Abstract: We analyze the optimal design of dynamic mechanisms in the absence of transfers. The designer uses future allocation decisions to elicit private information. Values evolve according to a two-state Markov chain. We solve for the optimal allocation rule, which permits 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 demonstrate that persistence hurts.
    Keywords: Mechanism design, Principal-Agent, Token mechanisms
    JEL: C73 D82
    Date: 2015–03
  3. By: Michael Hilmer
    Abstract: Using a simple symmetric principal-agent model with two banks, we study the effects of both bailouts and bonus taxes on risk taking and managerial compensation. We assume financial institutions to be systemic only on a collective basis, implying support with bailouts only if they both fail collectively. This too-many-to-fail assumption generates incentives for herding and collective moral hazard. If banks can anticipate bailouts, they can coordinate on an equilibrium in which they collectively incentivize higher risk-taking. A bonus tax can prevent this excessive risk-taking, even if it is implemented unilaterally: proper bonus taxation reduces risk-taking of the taxed bank(s) and, consequentially, rules out the equilibrium with excessive risk-taking of both banks and reestablishes market discipline.
    Keywords: Bonus Tax, Executive Compensation, Bailout, Systemic Risk, Too Many To Fail, Collective Moral Hazard
    JEL: H24 J3 M52 G38 D62
    Date: 2014–10
  4. By: Andreas Asseyer (Humboldt-Universitaet zu Berlin)
    Abstract: This paper studies optimal contracts and monitoring policies in procurement under dynamic adverse selection and moral hazard concerning a cost-reducing investment decision. I assume fixed costs of investment and show that the resulting 'lumpy' investment behavior creates a motive to monitor information that the supplier learns during the contractual relationship. The principal never monitors both the shock and the investment decision. Furthermore the principal is more likely to prefer to monitor the shock if the level of fixed cost of investment is high. Creation Date: 201502
    Keywords: procurement, lumpy investment, monitoring, dynamic information rents, dynamic contracts, dynamic mechanism design
    JEL: D82 D86 H57
  5. By: Noldeke, Georg (University of Basel); Larry Samuelson (Cowles Foundation, Yale University)
    Abstract: We use the theory of abstract convexity to study adverse-selection principal-agent problems and two-sided matching problems, departing from much of the literature by not requiring quasilinear utility. We formulate and characterize a basic underlying implementation duality. We show how this duality can be used to obtain a sharpening of the taxation principle, to obtain a general existence result for solutions to the principal-agent problem, to show that (just as in the quasilinear case) all increasing decision functions are implementable under a single crossing condition, and to obtain an existence result for stable outcomes featuring positive assortative matching in a matching model.
    Keywords: Implementation, Duality, Galois connection, Imperfectly transferable utility, Principal-agent model, Two-sided matching
    JEL: C62 C78 D82 D86
    Date: 2015–03
  6. By: Popov, Sergey V
    Abstract: Tenure contract is criticized for curbing the incentives for spending effort after obtaining the tenured status. Yet, the best faculty seems to work on a tenure contract, and schools who employ the best faculty seem to prefer to offer a tenure-track contract to their new hires. I argue that tenure-track contracts are by construction more attractive to more able freshly minted PhDs, and therefore the observed sorting is rationalizable.
    Keywords: tenure, academia, job market, self-selection
    JEL: I23 J4
    Date: 2015–03–19
  7. By: Olga Gorelkina (Max Planck Institute for Research on Collective Goods, Bonn)
    Abstract: Mechanism design theory strongly relies on the concept of Nash equilibrium. However, studies of experimental games show that Nash equilibria are rarely played and that subjects may be thinking only a finite number of iterations. We study one of the most influential benchmarks of mechanism design theory, the expected externality mechanism (D’Aspremont, Gerard-Varet, 1979) in a finite-depth environment described by the Lk model. While efficient implementation fails under certain conditions, our results provide a vindication of the mechanism in the convex quasi-linear environment with finitely-rational agents.
    Keywords: Bounded Rationality, Expected externality, externality mechanisms, Level-K
    JEL: D71 D82 C72
    Date: 2015–01
  8. By: Fabrizio Germano; Peio Zuazo-Garin
    Abstract: Economic predictions are highly sensitive to model and informational specifications. Weinstein and Yildiz (2007) show that, in static games with incomplete information, only very weak predictions, namely, the interim correlated rationalizable (ICR) actions, are robust to higher-order belief misspecifications. This paper extends their robustness analysis to allow for higher-order uncertainty about rationality. We introduce interim correlated p-rationalizability (ICRp) as a solution concept for games with incomplete information. We first confirm the robustness of the ICR predictions to small departures from common belief in rationality by showing the continuity of ICRp actions at p = 1, where they coincide with ICR. At the same time, we show that Weinstein and Yildiz's (2007) deeper results on the structure of rationalizability, most notably, their discontinuity and generic local uniqueness properties, fail as soon as any arbitrarily small amount of higher-order uncertainty about rationality is introduced. Thus, we find that common belief in rationality is a necessary condition for Weinstein and Yildiz's (2007) discontinuity property to hold. Among other things, this reveals the diminishing strategic impact of higher-order belief constraints.
    Keywords: robustness, rationalizability, uncertain rationality, incomplete information, belief hierarchies
    JEL: C72 D82 D83
    Date: 2015–02
  9. By: Hemous, David; Olsen, Morten
    Abstract: Do contractual frictions matter when firms are engaged in repeated interactions? This paper argues that long-term relationships, which allow firms to (partly) overcome the static costs associated with low contractibility, will under certain circumstances create dynamic inefficiencies. We consider the repeated interaction between final good producers and intermediate input suppliers, where the provision of the intermediate input is noncontractible. A producer/supplier pair can be a good match or a bad match, with bad matches featuring lower productivity. This allows us to build a cooperative equilibrium where producers can switch suppliers and start cooperation immediately with new suppliers. Every period, one supplier has the opportunity to innovate, and in the baseline model, innovations are imitated after one period. We show that (i) innovations need to be larger to break up existing relationships in the cooperative equilibrium than in either a set-up where the input is contractible or when we preclude cooperation in long-term relationships, (ii) the rate of innovation in the cooperative equilibrium is lower than in the contractible case, and may even be lower than in the non-cooperative equilibrium and (iii) cooperation may reduce welfare. Next, we assume that the frontier technology diffuses slowly to suppliers (instead of after one period). In that case, for sufficiently slow diffusion, the innovation rate in the cooperative equilibrium may be higher than even in the contractible case. Finally, we show that cooperation may also increase relationship specific innovations.
    Keywords: contractibility; innovation; relational contract; repeated game
    JEL: C73 K12 L14 O31 O43
    Date: 2015–03
  10. By: Boualem Djehiche; Peter Helgesson
    Abstract: In this paper we study a generalization of the continuous time Principal-Agent problem allowing for time inconsistent utility functions, for instance of mean-variance type. Using recent results on the Pontryagin maximum principle for FBSDEs we suggest a method of characterizing optimal contracts for such models. To illustrate this we consider a fully solved explicit example in the linear quadratic setting.
    Date: 2015–03
  11. By: Pedro Bordalo; Nicola Gennaioli; Andrei Shleifer
    Abstract: We present a theory of consumer choice that combines elements of limited recall and of allocationof attention distorted by salience. The theory helps clarify and organize a variety of evidence dealingwith consumer reaction to information, including surprises in quality and prices, unshrouding ofhidden attributes such as taxes or maintenance costs, and reminders. Our model explains howconsumers under or overreact to information, depending on what draws their attention. It also yieldsa normative analysis of reaction to reminders which adjusts the \sucient statistic" methodology.
    Date: 2015–03
  12. By: Maxim Troshkin (Cornell University); Ali Shourideh (University of Pennsylavnia)
    Abstract: This paper provides a theoretical and quantitative analysis of efficient pension systems as integral parts of the overall tax code. We study lifecycle environments with active intensive and extensive labor margins. First, we analytically characterize Pareto efficient policies when the main tension is between redistribution and provision of incentives: while it may be more efficient to have highly productive individuals work more and retire older, earlier retirement may be needed to give them incentives to fully realize their productivity when they work. We show that, under plausible conditions, efficient retirement ages increase with productivity. We also show that this pattern is implemented by pensions that not only depend on the age of retirement but are designed to be actuarially unfair. Second, using individual earnings and retirement data for the U.S. as well as intensive and extensive labor elasticities, we calibrate policy models to simulate robust implications: it is efficient for individuals with higher lifetime earning to retire (i) older than they do in the data (at 69.5 vs. at 62.8 in the data, for the most productive workers) and (ii) older than their less productive peers (at 69.5 for the most productive workers vs. at 62.2 for the least productive ones), in sharp contrast to the pattern observed in the U.S. data. Finally, we compute welfare gains of between 1 and 5 percent and total output gains of up to 1 percent from implementing efficient work and retirement age patterns. We argue that distorting the retirement age decision offers a powerful novel policy instrument, capable of overcompensating output losses from standard distortionary redistributive policies.
    Date: 2014
  13. By: George J. Mailath (Dept. of Economics, University of Pennsylvania); Andrew Postlewaite (Dept. of Economics, University of Pennsylvania); Larry Samuelson (Cowles Foundation, Yale University)
    Abstract: “Buy local” arrangements encourage members of a community or group to patronize one another rather than the external economy. They range from formal mechanisms such as local currencies to informal “I’ll buy from you if you buy from me” arrangements, and are often championed on social or environmental grounds. We show that in a monopolistically competitive economy, buy local arrangements can have salutary effects even for selfish agents immune to social or environmental considerations. Buy local arrangements effectively allow firms to exploit the equilibrium price-cost gap to profitably expand their sales at the going price.
    Keywords: Buy local, Local currency, Trading favors, Reciprocity, Monopolistic Competition
    JEL: D43 D85 L14 R12
    Date: 2015–03
  14. By: Emmanuel Farhi; Samuel Fraiberger; Xavier Gabaix; Romain Ranciere; Adrien Verdelhan
    Abstract: Since the Fall of 2008, out-of-the money puts on high interest rate currencies have become significantly more expensive than out-of-the-money calls, suggesting a large crash risk of those currencies. To evaluate crash risk precisely, we propose a parsimonious structural model that includes both Gaussian and disaster risks and can be estimated even in samples that do not contain disasters. Estimating the model for the 1996 to 2014 sample period using monthly exchange rate spot, forward, and option data, we obtain a real-time index of the compensation for global disaster risk exposure. We find that disaster risk accounts for more than a third of the carry trade risk premium in advanced countries over the period examined. The measure of disaster risk that we uncover in currencies proves to be an important factor in the cross-sectional and time-series variation of exchange rates, interest rates, and equity tail risk.
    Date: 2015–01

This nep-cta issue is ©2015 by Guillem Roig. 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.