nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2018‒11‒05
five papers chosen by
Guillem Roig
University of Melbourne

  1. Attention-driven demand for bonus contracts By Dertwinkel-Kalt, Markus; Köster, Mats; Peiseler, Florian
  2. Variation margins, fire sales, and information-constrained optimality By Biais, Bruno; Heider, Florian; Hoerova, Marie
  3. Optimal electricity demand response contracting with responsiveness incentives By Ren\'e A\"id; Dylan Possama\"i; Nizar Touzi
  4. Betrayal Aversion and the Effectiveness of Incentive Contracts By Rau, Holger; Müller, Stephan
  5. The causal effect of trust By Björn Bartling; Ernst Fehr; David Huffman; Nick Netzer

  1. By: Dertwinkel-Kalt, Markus; Köster, Mats; Peiseler, Florian
    Abstract: In many markets supply contracts include a series of small, regular payments made by consumers and a single, large bonus that consumers receive at some point during the contractual period. But, if for instance its production costs exceed its value to consumers, such a bonus creates inefficiencies. We offer a novel explanation for the frequent occurrence of bonus contracts, which builds on a model of attentional focusing. Our main result identifies market conditions under which bonus contracts should be observed: while a monopolist pays a bonus to consumers, if at all, only for low-value goods, firms standing in competition always - i.e., independent of the consumers' valuation - offer bonus contracts. Thus, competition does not eliminate but rather exacerbates inefficiencies arising from contracting with focused agents. Common contract schemes in markets for electricity, telephony, and bank accounts are consistent with our model, but cannot be reconciled with alternative approaches such as models on consumption smoothing, (quasi-)hyperbolic discounting, or switching costs.
    Keywords: Attention,Focusing,Bonus Contracts
    JEL: D91 D18 D40 L10
    Date: 2018
  2. By: Biais, Bruno; Heider, Florian; Hoerova, Marie
    Abstract: Protection buyers use derivatives to share risk with protection sellers, whose assets are only imperfectly pledgeable because of moral hazard. To mitigate moral hazard, privately optimal derivative contracts involve variation margins. When margins are called, protection sellers must liquidate some of their own assets. We analyse, in a general-equilibrium framework, whether this leads to inefficient fire sales. If investors buying in a fire sale interim can also trade ex ante with protection buyers, equilibrium is information-constrained efficient even though not all marginal rates of substitution are equalized. Otherwise, privately optimal margin calls are inefficiently high. To address this inefficiency, public policy should facilitate ex-ante contracting among all relevant counterparties. JEL Classification: G18, D62, G13, D82
    Keywords: constrained efficiency, fire sales, macro-prudential regulation, pecuniary externalities, variation margins
    Date: 2018–10
  3. By: Ren\'e A\"id; Dylan Possama\"i; Nizar Touzi
    Abstract: Despite the success of demand response programs in retail electricity markets in reducing average consumption, the literature shows failure to reduce the variance of consumers' responses. This paper aims at designing demand response contracts which allow to act on both the average consumption and its variance. The interaction between the producer and the consumer is modelled as a Principal-Agent problem, thus accounting for the moral hazard underlying demand response programs. The producer, facing the limited flexibility of production, pays an appropriate incentive compensation in order to encourages the consumer to reduce his average consumption and to enhance his responsiveness. We provide closed-form solution for the optimal contract in the case of linear energy valuation. Without responsiveness incentive, this solution decomposes into a fixed premium for enrolment and a proportional price for the energy consumed, in agreement with previously observed demand response contracts. The responsiveness incentive induces a new component in the contract with payment rate on the consumption quadratic variation. Finally, under the optimal contract with optimal consumer behaviour, the resulting consumption volatility may decrease as required, but it may also increase depending on the risk aversion parameters of both actors. This agrees with standard risk sharing effects. The calibration of our model to publicly available data of a large scale demand response experiment predicts a significant increase of responsiveness under our optimal contract, a significant increase of the producer satisfaction, and a significant decrease of the consumption volatility. The stability of our explicit optimal contract is justified by appropriate sensitivity analysis.
    Date: 2018–10
  4. By: Rau, Holger; Müller, Stephan
    Abstract: In this paper we study the impact of betrayal aversion on agents' effort provision, when principals have discretion regarding agents' remuneration. We show theoretically that agents who work under a nonbinding bonus contract face a trade off in their effort choice between the likelihood and the level of betrayal. Thus, depending on which effect predominates, betrayal aversion may either undermine or underpin the effectiveness of bonus contracts to induce effort. The data of our experiment reveal a strong detrimental effect of betrayal aversion. If the principal promises to pay a bonus for sufficiently high effort, the message is ineffective when agents are characterized by a high degree of betrayal aversion. In strong contrast, employees with a low degree of betrayal aversion increase their performance by more than 50%, if they received this message. The findings in this article identify an additional hidden cost of economic incentives.
    Keywords: Betrayal Aversion,Principal Agent Problem,Experiment
    JEL: C91 D03 D81
    Date: 2018
  5. By: Björn Bartling; Ernst Fehr; David Huffman; Nick Netzer
    Abstract: Trust affects almost all human relationships – in families, organizations, markets and politics. However, identifying the conditions under which trust, defined as people's beliefs in the trustworthiness of others, has a causal effect on the efficiency of human interactions has proven to be difficult. We show experimentally and theoretically that trust indeed has a causal effect. The duration of the effect depends, however, on whether initial trust variations are supported by multiple equilibria. We study a repeated principal-agent game with multiple equilibria and document empirically that an efficient equilibrium is selected if principals believe that agents are trustworthy, while players coordinate on an inefficient equilibrium if principals believe that agents are untrustworthy. Yet, if we change the institutional environment such that there is a unique equilibrium, initial variations in trust have short-run effects only. Moreover, if we weaken contract enforcement in the latter environment, exogenous variations in trust do not even have a short-run effect. The institutional environment thus appears to be key for whether trust has causal effects and whether the effects are transient or persistent.
    Keywords: Trust, causality, equilibrium selection, belief distortions, incomplete contracts, screening, institutions
    JEL: C91 D02 D91 E02
    Date: 2018–10

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