nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2017‒10‒29
two papers chosen by
Guillem Roig
University of Melbourne

  1. Procurement with Unforeseen Contingencies By Herweg, Fabian; Schmidt, Klaus M.
  2. Subjective Performance Evaluation of Employees with Biased Beliefs By FOSCHI, Matteo; SANTOS-PINTO, Luís Pedro

  1. By: Herweg, Fabian; Schmidt, Klaus M.
    Abstract: The procurement of complex projects is often plagued by large cost overruns. One important reason for these additional costs are flaws in the initial design. If the project is procured with a price-only auction, sellers who spotted some of the flaws have no incentive to reveal them early. Each seller prefers to conceal his information until he is awarded the contract and then renegotiate when he is in a bilateral monopoly position with the buyer. We show that this gives rise to three inefficiencies: inefficient renegotiation, inefficient production and inefficient design. We derive the welfare optimal direct mechanism that implements the efficient allocation at the lowest possible cost to the buyer. The direct mechanism, however, imposes strong assumptions on the buyer's prior knowledge of possible flaws and their payoff consequences. Therefore, we also propose an indirect mechanism that implements the same allocation but does not require any such prior knowledge. The optimal direct and indirect mechanisms separate the improvement of the design and the selection of the seller who produces the good.
    Keywords: Adaptation Costs; auctions; Behavioral Contract Theory; Design Flaws; Procurement; Renegotiation
    JEL: D44 D82 D83 H57
    Date: 2017–10
  2. By: FOSCHI, Matteo; SANTOS-PINTO, Luís Pedro
    Abstract: This paper analyses how worker optimism (and pessimism) affects subjective performance evaluation (SPE) contracts. We let an optimistic (pessimistic) worker overestimate (underestimate) the probability of observing an acceptable performance. The firm is better informed about performance than the worker and knows the worker's bias. We show that optimism (and pessimism): i) changes the optimal incentive scheme under SPE, ii) lowers the deadweight loss associated with SPE contracts, iii) can lead to a Pareto improvement by simultaneously lowering the firm's expected wage cost and raising the worker's expected compensation. In addition, we show that worker pessimism can lead to SPE contracts without a deadweight loss, in contrast to the standard case in the literature.
    Keywords: Optimism, Overconfidence, Contract, Moral Hazard, Biased Beliefs, Mechanism Design.
    JEL: D82 D84 D86 J41 J7
    Date: 2017

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