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on Contract Theory and Applications |
| By: | Matthias Fahn; Giorgio Zanarone |
| Abstract: | This paper studies how pay transparency affects organizations that reward employees based on their efforts (i.e., using “subjective performance evaluation”). First, we show that transparency triggers social comparisons that require the organization to pay its employees an “envy premium”. This premium reduces the value of the employment relationship to the organization, and thus its incentive to pay subjective bonuses to the hard-working employees. To restore credibility of its incentive system, a transparent organization must therefore reduce the weight of bonuses, and increase the weight of fixed salaries, in the employees’ compensation, relative to organizations that operate in a more conventional “pay secrecy” regime. Second, we show that transparency enables the employees to collectively sanction the organization for reneging on subjective incentives. Collective enforcement allows the transparent organization to use strong employment relationships to “cross-subsidize” weak ones, achieving a more balanced allocation of effort than under pay secrecy. We discuss testable implications of our model for compensation design, the choice between transparency and secrecy regimes, and organizational responses to pay transparency laws. |
| Keywords: | Social Comparisons, Secrecy, Transparency, Relational Contracts, Incentives. |
| JEL: | D03 D23 M52 M54 |
| Date: | 2021–01 |
| URL: | http://d.repec.org/n?u=RePEc:jku:econwp:2021-02&r=all |
| By: | Björn Bartling; Ernst Fehr; David B. Huffmann; Nick Netzer; David B. Huffman |
| Abstract: | Under weak contract enforcement the trading parties’ trust, defined as their belief in the other party’s trustworthiness, appears important for realizing gains from trade. In contrast, under strong contract enforcement beliefs about the other party’s trustworthiness appear less important, suggesting that trust and contract enforcement are substitutes. Here, we show, however, that trust and contract enforcement are complements. We demonstrate that in a weak contract enforcement environment trust has no effect on the gains from trade, but when we successively improve contract enforcement, larger effects of trust emerge. We also document that improvements in contract enforcement lead to no, or only small, increases in gains from trade under low initial trust, but generate high increases in gains from trade when initial trust is high. Thus, the effect of improvements in contract enforcement is trust-dependent, and the effect of increases in trust is dependent on the strength of contract enforcement. We identify three key ingredients underlying this complementarity: (1) heterogeneity in trading partners’ trustworthiness; (2) strength of contract enforcement affecting the ability to elicit reciprocal behavior from trustworthy types, and screen out untrustworthy types; (3) trust beliefs determining willingness to try such strategies. |
| Keywords: | trust, contract enforcement, complementarity, equilibrium selection, causal effect, screening, belief distortions, institutions |
| JEL: | C91 D02 D91 E02 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_8826&r=all |
| By: | Indranil Chakraborty; Fahad Khalil; Jacques Lawarree |
| Abstract: | Unlike standard auctions, we show that competitive procurement may optimally limit competition or use inefficient allocation rules that award the project to a less efficient firm with positive probability. Procurement projects often involve ex post moral hazard after the competitive process is over. A procurement mechanism must combine an incentive scheme with the auction to guard against firms bidding low to win the contract and then cutting back on effort. While competition helps reduce the rent of efficient firms, it exacerbates the problem due to moral hazard. If allocative efficiency is a requirement, limiting the number of participants may be optimal. Alternatively, the same incentives can be optimally provided using inefficient allocation rules. |
| Keywords: | competitive procurement, auctions, moral hazard |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_8863&r=all |
| By: | Martin, Jessica; Villeneuve, Stéphane |
| Abstract: | What type of delegation contract should be offered when facing a risk of the magnitude of the pandemic we are currently experiencing and how does the likelihood of an exogenous early termination of the relationship modify the terms of a full-commitment contract? We study these questions by considering a dynamic principal-agent model that naturally extends the classical Holmström-Milgrom setting to include a risk of default whose origin is independent of the inherent agency problem. We obtain an explicit characterization of the optimal wage along with the optimal action provided by the agent. The optimal contract is linear by offering both a fixed share of the output which is similar to the standard shutdown-free Holmström-Milgrom model and a linear prevention mechanism that is proportional to the random lifetime of the contract. We then tweak the model to add a possibility for risk mitigation through investment and study its optimality. |
| Keywords: | Principal-Agent problems, default risk, Hamilton-Jacobi Bellman equations |
| Date: | 2021–01–28 |
| URL: | http://d.repec.org/n?u=RePEc:tse:wpaper:125189&r=all |
| By: | Zongxia Liang; Yang Liu; Litian Zhang |
| Abstract: | Benchmarks in the utility function have various interpretations, including performance guarantees and risk constraints in fund contracts and reference levels in cumulative prospect theory. In most literature, benchmarks are a deterministic constant or a fraction of the underlying wealth; as such, the utility is still a univariate function of the wealth. In this paper, we propose a framework of multivariate utility optimization with general benchmark variables, which include stochastic reference levels as typical examples. The utility is state-dependent and the objective is no longer distribution-invariant. We provide the optimal solution(s) and fully investigate the issues of well-posedness, feasibility, finiteness and attainability. The discussion does not require many classic conditions and assumptions, e.g., the Lagrange multiplier always exists. Moreover, several surprising phenomena and technical difficulties may appear: (i) non-uniqueness of the optimal solutions, (ii) various reasons for non-existence of the Lagrangian multiplier and corresponding results on the optimal solution, (iii) measurability issues of the concavification of a multivariate utility and the selection of the optimal solutions, and (iv) existence of an optimal solution not decreasing with respect to the pricing kernel. These issues are thoroughly addressed, rigorously proved, completely summarized and insightfully visualized. As an application, the framework is adopted to model and solve a constraint utility optimization problem with state-dependent performance and risk benchmarks. |
| Date: | 2021–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2101.06675&r=all |