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on Contract Theory and Applications |
| By: | Armstrong, Christopher D. (University of Pennsylvania); Larcker, David F. (Stanford University); Su, Che-Lin (University of Chicago) |
| Abstract: | The two major paradigms in the theoretical agency literature are moral hazard (i.e., hidden action) and adverse selection (i.e., hidden information). Prior research typically solves these problems in isolation, as opposed to simultaneously incorporating both adverse selection and moral hazard features. We formulate two complementary generalized principal-agent models that incorporate features observed in real world contracting environments (e.g., agents with power utility and limited liability, lognormal stock price distributions, and stock options) as mathematical programs with equilibrium constraints (MPEC). We use state- of-the-art numerical algorithms to solve the resulting models. We find that many of the standard results no longer obtain when wealth effects are present. We also develop a new measure of incentives calculated as the change in the agent's certainty equivalent under the optimal contract for a change in action evaluated at the optimal action. This measure facilitates interpretation of the resulting contracts and allows us to compare contracts across different contracting environments. |
| JEL: | C60 C61 J33 M52 |
| Date: | 2010–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecl:stabus:2049&r=cta |
| By: | Elisabetta Iossa (Faculty of Economics, University of Rome "Tor Vergata"); Patrick Rey (Toulouse School of Economics) |
| Abstract: | Due to technological progress, recent performance is often more informative about future performance prospects than is older performance. We incorporate information decay in a career concern model in which performance depends on type and effort and contract renewal is based on the performance record. In contrast with the career concern literature (e.g. Lewis, 1986; RJE), contractors work harder when the project approaches renewal date and when their reputation is better. Productive investment are crowded out by window-dressing effort in late contract periods, but it is boosted in early periods. More frequent contract renewals strengthen reputational effects and result in improved performance if the relative cost of investment is low, but otherwise long-term contracts induce more effort. Our results are corroborated by some empirical studies showing that performance improves as the contract approaches renewal date. |
| Keywords: | Career concerns, contract renewal and dynamic incentives. |
| Date: | 2010–05–28 |
| URL: | http://d.repec.org/n?u=RePEc:rtv:ceisrp:155&r=cta |
| By: | Ojo, Marianne |
| Abstract: | In considering why practices which stimulate incentives for private agents to exert corporate control should be encouraged, this paper highlights criticisms attributed to government control of banks. However the theory relating to the “helping hand” view of government is advanced as having a fundamental role in the regulation and supervision of banks. Furthermore, governments have a vital role to play in corporate responsibility and regulation given the fact that banks are costly and difficult to monitor – this being principally attributed to the possibility that private agents will lack required incentives or the ability to supervise banks. Through its supervision of banks, governments also assume an important role where matters related to the fostering of accountability are concerned – not only because banks may have the power to affect firm performance, but also because some private agents are not able to afford internal monitoring mechanisms. Through the Enforced Self Regulation model, the paper attempts to highlight the role played by government in the direct monitoring of firms. In proposing the Co-operative and Competitive Enforced Self Regulation model, it attempts to draw attention to the fact that although such a model is based on a combination of already existing models and theories, the absence of effective enforcement mechanisms will restrict the maximisation potential of such a model. The primary theme of the paper relates to how corporate responsibility and accountability could be fostered through monitoring and the involvement of governments in the regulation of firms. It illustrates how structures which operate in various systems, namely, stock market economies and universal banking systems, function (and attempt) to address gaps which may arise as a result of lack of adequate mechanisms of accountability. Furthermore it draws attention to the impact of asymmetric information (generally and in these systems), on levels of monitoring procedures and how conflicts of interests which could arise between banks and their shareholders, or between governments and those firms being regulated by the regulator, could be addressed. |
| Keywords: | accountability; asymmetric information; universal banking; regulation; regulatory capture; government |
| JEL: | K2 G18 D82 G3 A10 G21 L1 |
| Date: | 2010–05–27 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:22918&r=cta |
| By: | Andrea Attar (Faculty of Economics, University of Rome "Tor Vergata"); Thomas Mariotti (Toulouse School of Economics); François Salanié (Toulouse School of Economics) |
| Abstract: | We consider an exchange economy in which a seller can trade an endowment of a divisible good whose quality she privately knows. Buyers compete in menus of non-exclusive contracts, so that the seller may choose to trade with several buyers. In this context, we show that an equilibrium always exists and that aggregate equilibrium allocations are generically unique. Although the good offered by the seller is divisible, aggregate equilibrium allocations exhibit no fractional trades. In equilibrium, goods of relatively low quality are traded at the same price, while goods of higher quality may end up not being traded at all if the adverse selection problem is severe. This provides a novel strategic foundation for Akerlof’s (1970) results, which contrasts with standard competitive screening models postulating enforceability of exclusive contracts. Latent contracts that are issued but not traded in equilibrium turn out to be an essential feature of our construction. |
| Keywords: | Adverse Selection, Competing Mechanisms, Non-Exclusivity |
| JEL: | D43 D82 D86 |
| Date: | 2010–05–28 |
| URL: | http://d.repec.org/n?u=RePEc:rtv:ceisrp:159&r=cta |
| By: | Santiago Sanchez-Pages |
| Abstract: | This paper studies bargaining and conflict under incomplete information, provides an overview and a critical account of the literature on the topic and contributes with original research. We first revise models of mechanism design and sequential bargaining that take confrontation as final. Conflict and inefficiencies are to be expected in these models whenever parties have optimistic prospects on the outcome of the all-out conflict. After examining the causes and reasons for this optimism, we move to the analysis of the recent literature that considers the existence of limited confrontations that allow bargaining to resume. In the presence of private information, these limited conflicts convey information and thus become a bargaining instrument. The paper closes with a discussion on the related empirical literature, the challenges that it faces and some potential avenues for further research. |
| Keywords: | Bargaining, Conflict, Incomplete information, Power, Optimism, Hicks paradox, Uneven contenders paradox. |
| JEL: | C78 D74 D82 |
| Date: | 2009–10 |
| URL: | http://d.repec.org/n?u=RePEc:edn:esedps:191&r=cta |
| By: | Robertas Zubrickas |
| Abstract: | Assuming that teachers are concerned with human capital formation and students - with ability signaling, in this paper we model a teacher-student relationship as an agency problem with conflicting interests. In our model, the teacher elicits effort from the student rewarding for it with a grade, the utility of which to the student is an ability signal inferred by the job market. In the event that the job market does not observe individual teachers' grading practice, teachers find grades as costless rewards and optimally choose to be lenient in grading. As a result, 'the problem of the commons'of good grades emerges leading to the depreciation of grading standards and grade inflation. The prediction of the model that the lower the expectations the teacher holds about her students' abilities, the flatter the grading rules she sets up is empirically supported. |
| Keywords: | Principal-agent model, teacher-student relationship, costless rewards, grading rules, mismatch of abilities and grades, grade inflation, teacher incentives |
| JEL: | C70 D82 D86 I20 |
| Date: | 2010–05 |
| URL: | http://d.repec.org/n?u=RePEc:zur:iewwpx:487&r=cta |
| By: | Maria Bigoni (Faculty of Economics, University of Bologna); Giancarlo Spagnolo (Faculty of Economics, University of Rome "Tor Vergata"); Paola Valbonesi (Faculty of Statistics, University of Padoa) |
| Abstract: | We study differently framed incentives in dynamic laboratory buyerseller relationships with multi-tasking and endogenous matching. The experimental design tries to mitigate the role of social preferences and intrinsic motivation. Absent explicit incentives, effort is low in both tasks. Their introduction boosts efficiency substantially increasing effort in the contractible task, mildly crowding it out in the non-contractible one, and increasing buyer surplus. Bonuses and penalties are equivalent for efficiency and crowding-out, but different in distributional effects: sellers’ surplus increases with bonuses as buyers’ offers become more generous. Buyers tend to prefer penalties, which may explain why they are dominant in procurement. |
| Keywords: | bonuses, business-to-business, contract choice, experiment, framing, explicit incentives, incomplete contracts, loss aversion, motivation, penalties, procurement, multi-tasking, relational contracts, rewards |
| JEL: | H57 C92 L14 M52 |
| Date: | 2010–05–28 |
| URL: | http://d.repec.org/n?u=RePEc:rtv:ceisrp:157&r=cta |
| By: | Winand Emons |
| Abstract: | We consider physicians with fixed capacity levels. If a physician's capacity exceeds demand, she may have an incentive to overtreat, i.e., she may provide unnecessary treatments to use up idle capacity. By contrast, with excess demand she may undertreat, i.e., she may not provide necessary treatments since other activities are financially more attractive. We first show that simple fee-for-service reimbursement schemes do not provide proper incentives. If insurers use, however, fee-for-service schemes with quantity restrictions, they solve the fraudulent physician problem. |
| Keywords: | credence goods; expert services; incentives; medical doctors; demand inducement; insurance |
| JEL: | D82 I11 |
| Date: | 2010–01 |
| URL: | http://d.repec.org/n?u=RePEc:ube:dpvwib:dp1001&r=cta |
| By: | Leandro Arozamena (Universidad Torcuato Di Tella & CONICET); Federico Weinschelbaum (Department of Economics, Universidad de San Andres) |
| Abstract: | We examine the problem of endogenous entry in a single-unit auction when the seller's welfare depends positively on the utility of a subset of potential bidders. We show that, unless the seller values those bidders?welfare more than her own ?private?utility, a nondiscriminatory auction is optimal. |
| Keywords: | auctions, favoritism, free entry, endogenous number of bidders |
| JEL: | C72 D44 |
| Date: | 2010–05 |
| URL: | http://d.repec.org/n?u=RePEc:sad:wpaper:103&r=cta |
| By: | Luigi Marengo; Corrado Pasquali |
| Abstract: | In this paper we present a model of the interplay between learning, incentives and the allocation of decision rights in the context of a generalized agency problem. Within this context, not only actors face conflicting interests but diverging cognitive ?visions? of the right course of action as well. We show that a principal may obtain the implementation of desired organizational policies by means of appropriate incentives or by means of appropriate design of the allocation of decisions, when the latter is cheaper but more complex. We also show that when the principal is uncertain about which course of action is more appropriate and wants to learn it from the environment, organizational structure and incentives interact in non-trivial ways and must be carefully tuned. When learning is not at stake, incentives and organizational structure are substitutes. When instead learning is at stake, organizational structure and incentives may complement each other and have to be fine tuned according to the complexity of the learning process and the competitive pressure which is put on fast or slow learning. |
| Keywords: | Incentives, Organizational Structure, Learning |
| Date: | 2010–05–25 |
| URL: | http://d.repec.org/n?u=RePEc:ssa:lemwps:2010/08&r=cta |
| By: | Pot Erik; Peeters Ronald; Peters Hans; Vermeulen Dries (METEOR) |
| Abstract: | In this paper we study the effect of information on the occurrence of intentional price wars on the equilibrium path. An episode of low prices is an intentional price war if it follows a period of high prices which was ended intentionally by one of the firms in the market (the price war leader). We show that for intentional price wars to exist on the equilibrium path, two elements are necessary regarding the information on which the firms base their decisions: (1) interperiod dynamics and (2) informational asymmetries. We illustrate this by means of a repeated price-setting game in which market shares fluctuate. Firms learn about the market share realizations at the beginning of each period. We show that intentional price wars on the equilibrium path are possible when firms have private information about their market share. When market shares are public information, we either see collusive price adjustment or episodes of low prices that do not classify as an intentional price war. |
| Keywords: | microeconomics ; |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:umamet:2010028&r=cta |
| By: | Christine Binzel; Dietmar Fehr |
| Abstract: | While social relationships play an important role for individuals to cope with missing market institutions, they also limit individuals' range of trading partners. This paper aims at understanding the determinants of trust at various social distances when information asymmetries are present. Among participants from an informal housing area in Cairo we find that the increase in trust following a reduction in social distance comes from the fact that trustors are much more inclined to follow their beliefs when interacting with their friend. When interacting with an ex-ante unknown agent instead, the decision to trust is mainly driven by social preferences. Nevertheless, trustors underestimate their friend's intrinsic motivation to cooperate, leading to a loss in social welfare. We relate this to the agents' inability to signal their trustworthiness in an environment characterized by strong social norms. |
| Keywords: | Trust, hidden action, social distance, solidarity, reciprocity, economic development |
| JEL: | C72 C93 D82 O12 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:diw:diwwpp:dp1007&r=cta |
| By: | Armstrong, Christopher S. (University of Pennsylvania); Jagolinzer, Alan D. (Stanford University); Larcker, David F. (Stanford University) |
| Abstract: | This study examines the use of performance-based incentives for internal monitors (general counsel and chief internal auditor) and whether these incentives impair monitors' independence by aligning their interests with the interests of those being monitored. We find evidence that incentives are greater when monitors' job duties contribute more to the firm's production function, when other top managers receive greater incentives, and when a firm has lower expected litigation risk. We also find evidence that firms provide more incentives when there is greater demand for internal monitoring. We find no evidence that internal monitor incentives impair the monitoring function. Instead, our results suggest that adverse firm outcomes (e.g., regulatory enforcement actions and internal-control material-weakness disclosures) occur less frequently at firms that provide greater monitor incentives. |
| Date: | 2010–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecl:stabus:2052&r=cta |
| By: | Buti, Sabrina (University of Toronto); Rindi, Barbara (Bocconi University); Werner, Ingrid M. (Ohio State University) |
| Abstract: | We model a dynamic limit order market with traders that submit orders either to a limit order book (LOB) or to a Dark Pool (DP). We show that there is a positive liquidity externality in the DP, that orders migrate from the LOB to the DP, but that overall trading volume increases when a DP is introduced. We also demonstrate that DP market share is higher when LOB depth is high, when LOB spreads are narrow, when there is more volatility, and when the tick size is larger. Further, while inside quoted depth in the LOB always decreases when a DP is introduced, quoted spreads can narrow for liquid stocks and widen for illiquid stocks. Finally, when .ash orders provide select traders with information about the state of the DP, we show that more orders migrate from the LOB to the DP. |
| Date: | 2010–03 |
| URL: | http://d.repec.org/n?u=RePEc:ecl:ohidic:2010-6&r=cta |
| By: | Biswas, Rongili; Marchese, Carla; Privileggi, Fabio |
| Abstract: | Gatekeepers have an increasing role in taxation and regulation. While burdening them with legal liability for misconducts that benefit those who resort to their services actually discourages wrongdoings — as will be clarified in the paper — an alienation effect can also arise. That is, the gatekeeper might become more interested in covering up the illegal behavior and in cooperating with the perpetrator. Such perverse effects are difficult to detect and to measure. This paper studies the problem with respect to tax evasion by firms, by building upon the classical Allingham and Sandmo (1972) model and by providing a more detailed description of the "concealment costs" than that available in the literature, which often simply makes assumptions about their existence and their functional form. The relationship between a risk neutral firm owner aiming at evading taxes and a risk averse gatekeeper is described through a simple principal-agent framework. The paper highlights the role of legal rules pertaining to liability for tax evasion in shaping the parties choices, since concealment costs vary according to whether the risk neutral principal or the risk averse agent are held responsible when tax evasion is detected. The main result of the analysis is that there are simple conditions under which one can easily infer whether harnessing the agent is socially beneficial. |
| Keywords: | tax evasion, firm, agency, risk aversion |
| JEL: | H26 H32 D81 K42 |
| Date: | 2009–12 |
| URL: | http://d.repec.org/n?u=RePEc:uca:ucapdv:138&r=cta |
| By: | Philipp Ackermann |
| Abstract: | Settlements are often considered to be welfare-enhancing because they save time and litigation costs. In the presence of court error, however, this conclusion may be wrong. Court decisions create positive externalities for future litigants which will not occur if a dispute is settled out of court. Focusing on private litigation, we examine the impact of court error on the deterrent effect of the strict liability rule. In an asymmetric information setup both, underdeterrence and overdeterrence are possible under court error. Moreover, court error increases the likelihood of out-of-court settlements which can offset the positive externality of litigation. |
| Keywords: | litigation; settlement; asymmetric information; court error; strict liability rule |
| JEL: | K13 K41 |
| Date: | 2010–02 |
| URL: | http://d.repec.org/n?u=RePEc:ube:dpvwib:dp1003&r=cta |
| By: | Liu, Qingmin (University of Pennsylvania); Skrzypacz, Andrzej (Stanford University) |
| Abstract: | We study the impact of limited records on reputation dynamics, that is, how the set of equilibria and equilibrium payoffs changes in a model in which one long-lived player faces a sequence of short-lived players who observe only limited information about past play (the last K periods of the long-lived player's actions). We show that limited records dramatically change the equilibrium behavior. Moreover, with limited records, equilibria in games with complete and incomplete information are strikingly different (in contrast to games with complete records). We also obtain a lower bound for equilibrium payoffs at any moment of the game, not only at the beginning, thus providing a stronger long-run prediction. |
| Date: | 2009–07 |
| URL: | http://d.repec.org/n?u=RePEc:ecl:stabus:2030&r=cta |
| By: | Tilman Borgers; Angel Hernanco-Veciana; Daniel Krohmer |
| Abstract: | The paper introduces a notion of complementarity (substitutability) of two signals which requires that in all decision problems each signal becomes more (less) valuable when the other signal becomes available. We provide a general characterization which relates complementarity and substitutability to a Blackwell comparison of two auxiliary signals. In a setting with a binary state space and binary signals, we find an explicit characterization that permits an intuitive interpretation of complementarity and substitutability. We demonstrate how these conditions extend to more general settings. |
| Keywords: | Complementarity, substitutability, value of information, Blackwell ordering. |
| JEL: | C00 C44 D81 D83 |
| Date: | 2010–04–11 |
| URL: | http://d.repec.org/n?u=RePEc:nwu:cmsems:1488&r=cta |
| By: | Ravikumar, B; Zhang, Yuzhe |
| Abstract: | We study the optimal auditing of a taxpayer's income in a dynamic principal-agent model of hidden income. Taxpayers in our model initially have low income and stochastically transit to high income that is an absorbing state. A low-income taxpayer who transits to high income can under-report his true income and evade his taxes. With a constant absolute risk-aversion utility function and a costly auditing technology, we show that the auditing mechanism in our model consists of cycles. Within each cycle, a low-income taxpayer is initially unaudited, but if the duration of low-income report exceeds a threshold, then the auditing probability becomes positive. That is, the tax authority guarantees that the taxpayer will not be audited until the threshold duration is reached. We also find that auditing becomes less frequent if the auditing cost is higher or if the variance of income is lower. |
| Keywords: | Tax compliance; Tax auditing; Stochastic costly state verification |
| JEL: | D82 |
| Date: | 2010–02 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:22924&r=cta |
| By: | Chung, Ji-Woong (Ohio State University); Sensoy, Berk A. (Ohio State University); Stern, Lea H. (Ohio State University); Weisbach, Michael S. (Ohio State University) |
| Abstract: | Incentives from the explicit fee structure ("two and twenty") of private equity funds understate the actual incentives facing private equity general partners because they ignore the rewards stemming from the effect of current performance on the ability to raise larger funds in the future. We evaluate the importance of these implicit incentives in the context of a learning model in which investors use current performance to update their assessments of a general partner's ability, and, in turn, decide how much capital to allocate to the partners' next fund. Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund. This implies that the performance-sensitive component of revenue is about twice as large as suggested by previous estimates based only on explicit fees. Consistent with the model, we find that these implicit incentives are stronger when abilities are more scalable and weaker when current performance is less informative about ability. Overall, the results suggest that implicit incentives from future fundraising have a substantial impact on general partners' welfare and are likely to be an important factor in the success of private equity firms. |
| Date: | 2010–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecl:ohidic:2010-3&r=cta |