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on Contract Theory and Applications |
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Issue of 2009‒02‒28
twenty-two papers chosen by Simona Fabrizi Massey University Department of Commerce |
| By: | Alberto Motta (University di Padova) |
| Abstract: | This paper studies the role of a policy of inducing in combating collusion within organizations, or in regulatory setups. In a mechanism-design problem involving a principal-supervisor-agent we show the role of endogenous selection of supervisory activity by the principal. One simple example is a mechanism in which the agent bypasses the supervisor and contracts directly with the principal in some states of the world. If collusion between supervisor and agent can occur only after they have decided to participate in the mechanism, this can costlessly eliminate collusion. This result is robust to alternative information structures, collusive behaviors and specification of agent's types. Applications include self-reporting of crimes, tax amnesties, immigration amnesties, work contracts specifying di¤erent degrees of discretion, mechanisms based on recommendation letters, embassies issuing immigration permits, and hiring committees. |
| Keywords: | Collusion, supervision, delegation, mechanism design. |
| JEL: | D82 C72 L51 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:pad:wpaper:0093&r=cta |
| By: | Schmitz, Patrick W. |
| Abstract: | In a complete contracting model, a risk-neutral seller exerts effort while producing a good. Effort is a hidden action and stochastically influences the risk-neutral buyer's valuation. Then the buyer can gather private information about his valuation. The ex ante optimal contract may encourage information gathering, even though it is commonly known that it is ex post efficient to trade regardless of the buyer's valuation (so that information gathering is a strategic, unproductive rent-seeking activity). Information gathering occurs even more often if it is a verifiable action. |
| Keywords: | complete contracting; hold-up problem; Information gathering |
| JEL: | D82 D86 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6988&r=cta |
| By: | Wambach, Achim |
| Abstract: | If bidders can acquire information during the auction the descending auction is no longer equivalent to a first-price-sealed-bid auction. Revenue equivalence does not hold. The incentive to acquire information can even be larger in a descending auction than in an ascending auction. |
| Keywords: | Descending auction; Dutch auction; First price sealed bid auction; Information acquisition |
| JEL: | D44 D82 D83 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7023&r=cta |
| By: | Antonio Cabrales; Piero Gottardi |
| Abstract: | In this paper we study, within a formal model, market environments where information is costly to acquire and is of use also to potential competitors. Agents may then sell, or buy, reports over the information acquired and choose the trades in the market on the basis of what they learnt. Reports are unverifiable - cheap talk messages - hence the quality of the information transmitted depends on the conflicts of interest faced by the senders. We find that, in equilibrium, information is acquired when its costs are not too high and in that case it is also sold, though reports are typically noisy. Also, the market for information tends to be a monopoly, and there is inefficiency given by underinvestment in information acquisition. Regulatory interventions in the form of firewalls, limiting the access to the sale of information to agents uninterested in trading the underlying object, only make the inefficiency worse. Efficiency can be attained with a monopolist selling differentiated information, provided entry is blocked. The above findings hold when information has a prevalent horizontal differentiation component. When the vertical differentiation element is more important firewalls can in fact be beneficial. |
| Keywords: | Information sale, Cheap talk, Conflicts of interest, Information Acquisition, Firewalls, Market efficiency |
| JEL: | D83 C72 G14 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:eui:euiwps:eco2009/11&r=cta |
| By: | Immordino, Giovanni; Pagano, Marco |
| Abstract: | We analyze corporate fraud in a model in which managers have superior information but are biased against liquidation, because of their private benefits from empire building. This may induce them to misreport information and even bribe auditors when liquidation would be value-increasing. To curb fraud, shareholders optimally choose auditing quality and the performance sensitivity of managerial pay, taking external corporate governance and auditing regulation into account. For given managerial pay, it is optimal to rely on auditing when external governance is in an intermediate range. When both auditing and incentive pay are used, worse external governance must be balanced by heavier reliance on both of those incentive mechanisms. In designing managerial pay, equity can improve managerial incentives while stock options worsen them. |
| Keywords: | accounting fraud; auditing; corporate governance; managerial compensation; regulation |
| JEL: | G28 K22 M42 |
| Date: | 2008–12 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7104&r=cta |
| By: | Vives, Xavier |
| Abstract: | A Bayesian supply function equilibrium is characterized in a market where firms have private information about their uncertain costs. It is found that with supply function competition, and in contrast to Bayesian Cournot competition, competitiveness is affected by the parameters of the information structure: supply functions are steeper with more noise in the private signals or more correlation among the costs parameters. In fact, for large values of noise or correlation supply functions are downward sloping, margins are larger than the Cournot ones, and as we approach the common value case they tend to the collusive level. Furthermore, competition in supply functions aggregates the dispersed information of firms (the equilibrium is privately revealing) while Cournot competition does not. The implication is that with the former the only source of deadweight loss is market power while with the latter we have to add private information. As the market grows large the equilibrium becomes competitive and we obtain an approximation to how many competitors are needed to have a certain degree of competitiveness. |
| Keywords: | adverse selection; collusion; competitiveness; imperfect competition; rational expectations; welfare |
| JEL: | D44 D82 L13 L94 |
| Date: | 2008–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6960&r=cta |
| By: | Jeanne, Olivier; Ostry, Jonathan D; Zettelmeyer, Jeronimo |
| Abstract: | We present a framework that clarifies the financial role of the IMF, the rationale for conditionality, and the conditions under which IMF-induced moral hazard can arise. In the model, traditional conditionality commits country authorities to undertake crisis resolution efforts, facilitating the return of private capital, and ensuring repayment to the IMF. Nonetheless, moral hazard can arise if there are crisis externalities across countries (contagion) or if country authorities discount crisis costs too much relative to the national social optimum, or both. Moral hazard can be avoided by making IMF lending conditional on crisis prevention efforts - "ex ante" conditionality. |
| JEL: | F02 F32 F33 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7022&r=cta |
| By: | Bolhaar, Jonneke; Lindeboom, Maarten; van der Klaauw, Bas |
| Abstract: | We investigate the presence of moral hazard and advantageous or adverse selection in a market for supplementary health insurance. For this we specify and estimate dynamic models for health insurance decisions and health care utilization. Estimates of the health care utilization models indicate that moral hazard is not important. Furthermore, we find strong evidence for advantageous selection, largely driven by heterogeneity in education, income and health preferences. Finally, we show that ignoring dynamics and unobserved fixed effects changes the results dramatically. |
| Keywords: | advantageous selection; health care utilization; moral hazard; panel data; supplementary private health insurance |
| JEL: | C33 D82 G22 I11 |
| Date: | 2008–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6968&r=cta |
| By: | Bennardo, Alberto; Pagano, Marco; Piccolo, Salvatore |
| Abstract: | When a customer can borrow from several competing banks, multiple lending raises default risk. If creditor rights are poorly protected, this contractual externality can generate novel equilibria with strategic default and rationing, in addition to equilibria with excessive lending or non-competitive rates. Information sharing among banks about clients' past indebtedness lowers interest and default rates, improves access to credit (unless the value of collateral is very uncertain) and may act as a substitute for creditor rights protection. If information sharing also allows banks to monitor their clients' subsequent indebtedness, the credit market may achieve full efficiency. |
| Keywords: | creditor rights; information sharing; multiple-bank lending; non-exclusivity; seniority |
| JEL: | D73 K21 K42 L51 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7186&r=cta |
| By: | Hoppe, Eva I.; Schmitz, Patrick W. |
| Abstract: | The government wants a certain good or service to be provided. Should the required assets be publicly or privately owned or should a partnership be formed? Building on the incomplete contracting approach, we argue that the initially specified quantity of an ex ante describable basic good can have important effects on investment incentives, which has been neglected in the literature so far. We also study how the tasks of investing in quality improvements and cost reductions should be assigned. We show how the optimal contracts and governance structures depend on the exogenous parameters of the model such as the nature of the investments and the parties' bargaining powers. |
| Keywords: | Contractible control; Incomplete contracts; Privatization |
| JEL: | D23 D86 H11 L33 |
| Date: | 2008–11 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7056&r=cta |
| By: | Emons, Winand; Fluet, Claude |
| Abstract: | Two firms produce a product with a horizontal and a vertical characteristic. We call the vertical characteristic quality. The difference in the quality levels determines how the firms share the market. Firms know the quality levels, consumers do not. Under non-comparative advertising a firm may signal its own quality. Under comparative advertising firms may signal the quality differential. In both scenarios the firms may attempt to mislead at a cost. If firms advertise, in both scenarios equilibria are revealing. Under comparative advertising the firms never advertise together which they may do under non-comparative advertising. |
| Keywords: | advertising; costly state falsification; signalling |
| JEL: | D82 K41 K42 |
| Date: | 2009–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7109&r=cta |
| By: | Loranth, Gyongyi; Morrison, Alan |
| Abstract: | We examine the interdependency between loan officer compensation contracts and commercial bank internal reporting systems (IRSs). The optimal incentive contract for bank loan officers may require the bank headquarters to commit not to act on certain types of information. The headquarters can achieve this by running a basic reporting system that restricts information flow within the bank. We show that origination fees for loan officers emerge naturally as part of the optimal contract in our set-up. We examine the likely effect of the new Basel Accord upon IRS choice, loan officer compensation, and bank investment strategies. We argue that the new Accord reduces the value of commitment, and hence that it may reduce the number of marginal projects financed by banks. |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7155&r=cta |
| By: | Harun Onder (Department of Economics, Florida International University) |
| Abstract: | This paper analyzes the structure of cooperation between two large countries under one-sided incomplete information. Foreign government privately observes its likelihood of experiencing a political economy shock in each period. Home government’s prior belief about this likelihood is updated in a Bayesian fashion as the relationship continues. We show that the home government employs its privilege to design a contract so as to start with a few-goods-agreement, and increase the extent of cooperation gradually as its belief is favorably updated through periods. We also provide the conditions under which the home government makes the partner reveal its type in the beginning, or enables it to stay in a cooperative relationship without a complete revelation. As opposed to conventional approaches that relate gradualism with cost of liberalization, we show that asymmetric information provides a sufficient reason for gradualism to emerge. |
| Keywords: | Gradualism, Free Trade Agreements, Asymmetric Information |
| JEL: | F13 F15 D82 D86 F53 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:fiu:wpaper:0905&r=cta |
| By: | Acharya, Viral V; DeMarzo, Peter; Kremer, Ilan |
| Abstract: | We consider the release of information by a firm when the manager has discretion regarding the timing of its release. While it is well known that firms appear to delay the release of bad news, we examine how external information about the state of the economy (or the industry) affects this decision. We develop a dynamic model of strategic disclosure in which a firm may privately receive information at a time that is random (and independent of the state of the economy). Because investors are uncertain regarding whether and when the firm has received information, the firm will not necessarily disclose the information immediately. We show that bad news about the economy can trigger the immediate release of information by firms. Conversely, good news about the economy can slow the release of information by firms. As a result, the release of negative information tends to be clustered. Surprisingly, this result holds only when firms can preempt the arrival of external information by disclosing their own information first. These results have implications for conditional variance and skewness of stock and market returns. |
| Keywords: | disclosure; disclosure dynamics; disclosure timing; earnings announcement; skewness; stochastic volatility; strategic disclosure |
| JEL: | D82 G14 G3 M4 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6985&r=cta |
| By: | Lóránth, Gyöngyi; Morrison, Alan |
| Abstract: | We examine the interdependency between loan officer compensation contracts and commercial bank internal reporting systems (IRSs). The optimal incentive contract for bank loan officers may require the bank headquarters to commit not to act on certain types of information. The headquarters can achieve this by running a basic reporting system that restricts information flow within the bank. We show that origination fees for loan officers emerge naturally as part of the optimal contract in our set-up. We examine the likely effect of the new Basel Accord upon IRS choice, loan officer compensation, and bank investment strategies. We argue that the new Accord reduces the value of commitment, and hence that it may reduce the number of marginal projects financed by banks. |
| Keywords: | capital regulation; compensation; internal reporting system |
| JEL: | G20 G21 G30 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7179&r=cta |
| By: | Audretsch, David B; Bönte, Werner; Mahagaonkar, Prashanth |
| Abstract: | Innovative new ventures fail if they cannot attract resources needed to commercialise new ideas and inventions. Obtaining external resources is a central issue for nascent entrepreneurs - people who are in the process of starting new ventures. We argue in this paper that, a way to deal with this problem is to signal appropriability and feasibility of innovation to the financiers through patenting and prototyping activities, right in the early stages of the venture. We build a new dataset of over 900 nascent entrepreneurs with information on financing from conventional sources as well as business angels and venture capitalists. Our results suggest that patenting and prototyping increase the likelihood of obtaining external finance, especially equity. However, the most important determinant of debt is house ownership. This indicates that new start-ups need to protect their innovations and at the same time, should also prototype the intended product in order to obtain start-up finance. New ventures should therefore strategically use their innovativeness in order to obtain external finance. |
| Keywords: | Entrepreneurship; Finance; Information Asymmetries; Innovation |
| JEL: | G14 G24 G32 L26 M13 O34 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7165&r=cta |
| By: | Kozo Ueda (Institute for Monetary and Economic Studies, Deputy Director and Bank of Japan (Email: kouzou.ueda boj.or.jp)) |
| Abstract: | We construct a simple model in which a central bank communicates with money market traders. We demonstrate that there exist multiple equilibria. In one equilibrium, traders truthfully reveal their own information, and by learning this, the central bank can make better forecasts. Another equilibrium is a gdog-chasing-its-tailh equilibrium in Blinder (1998). Traders mimic the central bankfs forecast, so the central bank simply observes its own forecast from traders. The latter equilibrium is socially worse in that inflation variability becomes larger. We also demonstrate that too high transparency of central banks is bad because it yields the gdog-chasing-its-tailh equilibrium, and that central banks should conduct continuous monitoring or emphasize that their forecasts are conditional because doing so eliminates the gdog- chasing-its-tailh equilibrium. |
| Keywords: | Transparency, disclosure, coordination |
| JEL: | C72 D83 E52 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:ime:imedps:09-e-05&r=cta |
| By: | Franklin Allen; Elena Carletti; Robert Marquez |
| Abstract: | It is commonly believed that equity finance for banks is more costly than deposits. This suggests that banks should economize on the use of equity and regulatory constraints on capital should be binding. Empirical evidence suggests that in fact this is not the case. Banks in many countries hold capital well in excess of regulatory minimums and do not change their holdings in response to regulatory changes. We present a simple model of bank moral hazard that is consistent with this observation. In perfectly competitive markets, banks can find it optimal to use costly capital rather than the interest rate on the loan to guarantee monitoring because it allows higher borrower surplus. |
| Keywords: | credit market competition, monitoring, loan rates, capital, bank monitoring |
| JEL: | G21 G31 D4 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:eui:euiwps:eco2009/08&r=cta |
| By: | Kaniska Dam; Marc Escrihuela-Villar; Santiago Sanchez-Pages |
| Abstract: | We analyse risk-taking behaviour of banks in the context of spatial competition. Banks mobilise unsecured deposits by offering deposit rates, which they invest either in a prudent or a gambling asset. Limited liability along with high return of a successful gamble induce moral hazard at the bank level. We show that when the market power is low, banks invest in the gambling asset. On the other hand, for sufficiently high levels of market power, all banks choose the prudent asset to invest in. We further show that a merger of two neighboring banks increases the likelihood of prudent behaviour. Finally, introduction of a deposit insurance scheme exacerbates banks’ moral hazard problem. |
| JEL: | D43 G28 G34 |
| Date: | 2009–02 |
| URL: | http://d.repec.org/n?u=RePEc:edn:esedps:187&r=cta |
| By: | Alberto Motta (University di Padova) |
| Abstract: | This paper studies the optimal compensation policy for a corruptible inspector, in charged with monitoring evasion from a taxpayer. Namely, I discuss how the optimal compensation policy varies according to the timing of collusion, which is allowed to occur either before or after inspection takes place. This paper shows that increasing the bonus rate is a better policy than increasing the penalty rate when corruption occurs after inspection. The contrary is true when the collusive agreement is established before the inspection. Implications for privatization of law enforcement are analyzed. |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:pad:wpaper:0094&r=cta |
| By: | Drugov, Mikhail; Macchiavello, Rocco |
| Abstract: | For many self-employed poor in the developing world, entrepreneurship involves experimenting with new technologies and learning about oneself. This paper explores the (positive and normative) implications of learning for the practice of lending to the poor. The optimal lending contract rationalizes several common aspects of microlending schemes, such as "mandatory saving requirements", "progressive lending" and "group funds". Joint liability contracts are, however, not necessarily optimal. Among the poorest borrowers the model predicts excessively high retention rates, the contemporaneous holding of borrowing and savings at unfavorable interest rates as well as the failure to undertake profitable and easily available investment opportunities, such as accepting larger loans to scale-up business. Further testable predictions can be used to interpret and guide the design of controlled field experiments to evaluate microlending schemes. |
| Keywords: | Credit Constraints; Group Lending; Microlending Schemes; Savings; Scaling-Up; Self-Discovery |
| JEL: | D14 O14 O16 |
| Date: | 2008–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:7011&r=cta |
| By: | Li, Yanfei; Yao, Shuntian; Chia, Wai-Mun |
| Abstract: | Increasing evidence shows that ICT investment improves firm performance. Among the many explanations on why ICT contributed to labor productivity surge since 1990, this is the most promising one. It is thus necessary to take the firm as an information processing organization, putting it in stochastic environment. As perfect information is no longer the assumption, that firms exogenously exist in the economy would no longer be assumed here. With these in mind, the paper provides a model that involves the division of labor and specialization, the production and consumption under demand uncertainty, and the value of information. It shows that under certain business conditions, a firm with certain type of information processing ability comes into being endogenously. A surplus, which could reasonably be argued as information rent, is generated with firm production. The size of this information rent depends on a few key parameters, including the level of uncertainty, the degree of market competition, and the cost of information processing. To test the model, case studies on the financial industry and the wholesale and retail industry are conducted, which corroborate the theoretical predictions of the model. |
| Keywords: | demand uncertainty; information processing; firm; information rent |
| JEL: | D2 L2 D8 D4 L1 |
| Date: | 2009–02–12 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:13506&r=cta |