nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2021‒05‒10
three papers chosen by
Guillem Roig
University of Melbourne

  1. On the Optimality of Outsourcing when Vertical Integration can Mitigate Information Asymmetries By Schmitz, Patrick W.
  2. Employment Flexibility and Capital Structure: Evidence from a Natural Experiment By Kuzmina, Olga
  3. Contingent Contracts in Banking: Insurance or Risk Magnification? By Gersbach, Hans

  1. By: Schmitz, Patrick W.
    Abstract: Consider a buyer and a seller who have agreed to trade an intermediate good. It is ex-post efficient to adapt the good to the prevailing state of the world. The seller has private information about the costs of adapting the good. In the case of non-integration, the buyer has no possibility to verify claims that the seller makes about her costs. In the case of vertical integration, the buyer can verify evidence about the costs that the seller might be able to provide. Even though we assume no further differences between the ownership structures, it turns out that the parties may prefer non-integration.
    Keywords: Incomplete Contracts; Make-or-buy decision; Outsourcing; private information; Property rights approach
    JEL: D23 D82 D86 L24 M11
    Date: 2021–03
  2. By: Kuzmina, Olga
    Abstract: Exploiting the variation in labor-market programs in Spain, I show that the use of flexible (shorter and cheaper-to-fire) employment contracts increases a firm's debt capacity. A thought experiment of prohibiting an average firm from hiring workers on flexible contracts suggests that such a firm should reduce its debt-to-capital ratio by 7%. I further nail down the employment flexibility mechanism behind this effect, which works through reductions of the firm's operating leverage and the fixity of its costs. I use specific institutional features to separate this explanation from differences in wages or labor bargaining power. I show that the effects are stronger for firms suffering most in bankruptcy and that in downturns, firms downsize using flexible labor, implying that the employment-contract structure is a significant component of operating flexibility and expected default costs. Finally, employment flexibility increases firm value for firms that benefit most from operating leverage reductions and depend more on external financing. The results demonstrate how management can use heterogenous labor contracts to improve firm outcomes. Most broadly, the results emphasize the importance of studying operating strategy and organizational structure as integral determinants of the financing decisions of firms and highlight the complementarities between CEOs' and CFOs' decision-making.
    Keywords: Capital Structure; Fixed-term contracts; Operating flexibility; Operating Leverage
    JEL: D22 G32 J41
    Date: 2021–02
  3. By: Gersbach, Hans
    Abstract: What happens when banks compete with deposit and loan contracts contingent on macroeconomic shocks? We show that the private sector insures the banking system efficiently against banking crises through such contracts when banks focus on expected profit maximization and failing banks go bankrupt. When risks are large, banks may shift part of the risk to depositors who receive state-contingent contracts. Repackaging of the risk among depositors can improve welfare. In contrast, when failing banks are rescued, new phenomena such as risk creation or magnification emerge, which would not occur with non-contingent contracts. In particular, depositors receive non-contingent contracts with comparatively high interest rates, while entrepreneurs obtain loan contracts that demand high repayment in good times and low repayment in bad times. As a result, banks overinvest and generate large macroeconomic risks, even if the underlying productivity risk is small or zero.
    Keywords: Financial intermediation - Macroeconomics risks - State-contingent contracts - Banking regulation
    JEL: D41 E4 G2
    Date: 2021–03

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