Objective versus Subjective Performance Evaluations

Abstract:

Why does incentive pay often depend on subjective rather than objective performance evaluations? After all, subjective evaluations entail a credibility issue. While the most plausible explanation for this practice is lack of adequate objective measures, I argue that subjective evaluations might sometimes also be used to withhold information from the worker. I furthermore argue that withholding information is particularly important under circumstances where the credibility issue is small. The statements are derived from a two-stage principal-agent model in which the stochastic relationship between effort and performance is unknown.

Keywords: Performance evaluation, principal-agent, moral hazard

JEL Codes: D83, D86, M12, M52

Full text in pdf format:

430.pdf

Precontractual Investigation and Sequential Screening

Abstract:

Should contract design induce an agent to conduct a precontractual investigation even though, in any case, the agent will become fully informed after the signing of the contract? This paper shows that imperfect investigations might be encouraged. The result stands in contrast to previous studies, which focus on perfect investigations. The contrast exists because if precontractual investigation is perfect, the benefits of sequential screening vanish.

Keywords: Principal agent, information acquisition, sequential screening

JEL Codes: D82, D83, D86

Full text in pdf format:

429.pdf

Acquisition and Disclosure of Information as a Hold-up Problem

Abstract:

The acquisition of information prior to sale gives rise to a hold-up situation quite naturally. Yet, while the bulk of the literature on the hold-up problem considers negotiations under symmetric information where cooperative short-cuts such as split the difference capture the outcome of bargaining, in the present setting, parties negotiate under asymmetric information where the outcome must be derived from a non-cooperative bargaining procedure. To avoid the difficult task of specifying and solving complicated games combining elements of signalling and screening, but to still compare incentives for acquiring information under voluntary versus mandatory disclosure, use of conditions such as incentive, disclosure and participation constraints only is made that are common to all non-cooperative bargaining outcomes.

JEL classification: K12, K13

Keywords: mistake, information acquisition, disclosing information

Full text in pdf format:

428.pdf

Optimal Sequential Delegation

Abstract:

The paper extends the optimal delegation framework pioneered by Holmström (1977, 1984) to a dynamic environment where, at the outset, the agent privately knows his ability to interpret decision relevant private information received later on. We show that any mechanism can be implemented by a sequential menu of delegation sets where the agent first picks a delegation set and then chooses an action within this set. For the uniform{quadratic case, we characterize when sequential delegation is strictly better than static delegation and derive the optimal delegation menu. We provide sufficient conditions so that our results extend beyond the uniform distribution.

Keywords: optimal delegation, sequential screening, dynamic mechanism design,

non-transferable utility.

JEL Codes: D02, D20, D82, D86.

Full text in pdf format:

427.pdf

Exit Options and the Allocation of Authority

Abstract:

We analyze the optimal allocation of authority in an organization whose members have conflicting preferences. One party has decision-relevant private information, and the party who obtains authority decides in a self-interested way. As a novel element in the literature on decision rights, we consider exit option contracts: the party without decision rights is entitled to prematurely terminate the relation after the other party's choice. We show that under such a contract it is always optimal to assign authority to the informed and not to the uninformed party, irrespective of the parties' conflict of interest. Indeed, the first-best efficient solution can be obtained by such a contract.

Keywords: Authority, decision rights, exit options, incomplete contracts, asymmetric information.

JEL Classification No.: D23, D82, D86.

Full text in pdf format:

401.pdf

Delays in Leniency Application: Is There Really a Race to the Enforcer’s Door?

Abstract:

This paper studies cartels’ strategic behavior in delaying leniency applications, a take-up decision that has been ignored in the previous literature. Using European Commission decisions issued over a 16-year span, we show, contrary to common beliefs and the existing literature, that conspirators often apply for leniency long after a cartel collapses. We estimate hazard and probit models to study the determinants of leniency-application delays. Statistical tests find that delays are symmetrically affected by antitrust policies and macroeconomic fluctuations. Our results shed light on the design of enforcement programs against cartels and other forms of conspiracy. Journal of Economic Literature

Classification Numbers: D43, K21, K42, L13.
Keywords: corporate leniency program, cartel, leniency application delays

Full text in pdf format:

395.pdf

Cartel Duration and Endogenous Private Monitoring and Communication: An Instrumental Variables Approach

Abstract:

Colluding firms often exchange private information and make transfers within the cartels based on the information. Estimating the impact of such collusive practices— known as the “lysine strategy profile (LSP)”— on cartel duration is difficult because of endogeneity and omitted variable bias. I use firms’ linguistic differences as an instrumental variable for the LSP in 135 cartels discovered by
the European Commission since 1980. The incidence of the LSP is not  significantly related to cartel duration. After correction for selectivity in the decision to use the LSP, statistical tests are consistent with a theoretic prediction that the LSP increases cartel duration.
Keywords: the lysine strategy profile, post-agreement information exchange, within-cartel transfers, monitoring, verification and promotion of compliance, cartel duration, endogenous covariates
JEL classification: D43, K21, K42, L13.

Full text in pdf format:

369.pdf

Vicarious Liability and the Intensity Principle

Abstract:

The present paper provides an economic analysis of vicarious liability that takes information rents and monitoring costs to be borne by the principal explicitly into account. In the presence of information rents or if the principal is wealth constrained herself, vicarious liability need not generate efficient precaution incentives. Rather, precaution incentives turn out to depend on the exact quantum of damages specified by courts. I shall compare incentives under three damages
regimes: strict liability, the traditional negligence rule, and proportional liability. To do so, I make use of the intensity principle that allows to rank damages regimes based on the monotonicity of differences of the principal's expected payof f as a function of induced precaution.

Keywords: vicarious liability, precaution incentives, judgement-proof principals and agents, discrepancy between private and social costs

JEL classification: K13, D62

October 2011

Full text in pdf format:

364.pdf

The Benefits of Sequential Screening

Abstract:

This paper considers the canonical sequential screening model and shows that when the agent has an expost outside option, the principal does not benefit from eliciting the agent’s information sequentially. Unlike in the standard model without expost outside options, the optimal contract is static and conditions only on the agent’s aggregate final information. The benefits of sequential screening in the standard model are therefore due to relaxed participation rather than relaxed incentive compatibility constraints. We argue that in the presence of expost participation constraints, the classical, local approach fails to identify binding incentive constraints and develop a novel, inductive procedure to do so instead. The result extends to the multi–agent version of the problem.

Keywords: Sequential screening, dynamic mechanism design, participation constraints, Mirrlees approach

JEL Classification: D82, H57

October 2011

Full text in pdf format:

363.pdf

A Note on “Modeling the Birth and Death of Cartels with An Application to Evaluating Competition Policy” by Harrington and Chang (2009)

Abstract:

Full text in pdf format:

362.pdf

Evaluating Leniency with Missing Information on Undetected Cartels: Exploring Time-Varying Policy Impacts on Cartel Duration

Abstract:

This paper examines the effects of European Commission’s (EC) new leniency program on the EC’s capabilities in detecting and deterring cartels. As a supplementary analysis, the US leniency is studied. I discuss a dynamic model of cartel formation and dissolution to illustrate how changes in antitrust policies and economic conditions might affect cartel duration. Comparative statics results are then corroborated with empirical estimates of hazard functions adjusted to account for both the heterogeneity of cartels and the time-varying policy impacts suggested by theory. Contrary to earlier studies, my statistical tests are consistent with the theoretic predictions that following an efficacious leniency program, the average duration of discovered cartels rises in the short run and falls in the long run. The results shed light on the design of enforcement programs against cartels and other forms of conspiracy.

Keywords: evaluation of antitrust policies, leniency, time-varying policy effects, missing observations,

sample selection bias.

Journal of Economic Literature Classification Numbers: D43, K21, K42, L13.

Full text in pdf format:

353_01.pdf

Determinants of Noneconomic Damages in Medical Malpractice Settlements and Litigations: Evidence from Texas since 1988

Abstract:

There have long been claims that compensations for noneconomic damages are random because tort law does not provide clear guidance regarding these compensations. I investigate, in both settled and tried medical malpractice cases, whether noneconomic damage payments are arbitrary and what determines the probability and size of these payments. I find that payments for noneconomic damages are not completely random. They vary, in predictable ways, with observable characteristics of the case. The data suggest similar patterns in non-medical malpractice cases. I end by discussing the implications of my findings for the debate on the efficiency and rationale of noneconomic damage compensation.

JEL Classification: K13, K32, K41

December 2010

Full text in pdf format:

348.pdf

The Timing of Out-of-Court Settlements Revisited: Theory and Cross- Sectional Evidence from Texas since 1988

Abstract:

Legal institutions play an important role in affecting delay in settlement. But little research has investigated the institutional causes of delay. The empirical literature is ambiguous regarding the impact of trial-court delay on settlement delay. I analyze the timing of bargaining and the causes of delay using a cross-section of insurance claims in Texas over a 20-year span. I discuss a dynamic model of pretrial negotiation to illustrate how changes in the legal systems might affect the duration of settlement. Comparative statics results are then corroborated with empirical estimates of a hazard function adjusted to account for the heterogeneity of claims and the time dependence suggested by theory. Statistical tests are consistent with the theoretic prediction that delay in trial courts expedites out-of-court settlement. I also find that alternative dispute resolution, a legal process designed to save transaction costs, reduces the rapidity of settlement. Prejudgement interest, a law introduced to reduce delay, actually causes a greater delay in settlement. The results have implications for efficiency of the judicial system and reform efforts aiming to reduce delay.

Keywords: settlement delay, trial-court delay, prejudgment interest, alternative dispute resolution

JEL-Classification: C78, K41

December 2010

Full text in pdf format:

347_01.pdf

Jackpot Justice: The Value of Inefficient Litigation

Abstract:

Litigation seems to be a Pareto-ineffcient outcome of pretrial bargaining; however, this paper shows that litigation can be the outcome of rational behavior by a litigant and her attorney. If the attorney has more information than his client concerning the characteristics of the lawsuit, the client can use litigation as a way of extracting information. I show that, counterintuitively, litigation will occur only when the plaintiff is pessimistic about her prospects at trial. Even if the plaintiff could obtain a higher payoff from bargaining than from litigation-without-bargaining, bargaining may not occur in equilibrium. The plaintiff is more likely to sue if she is more pessimistic about winning damage in court and if litigation is more risky. Litigation is less likely to occur if the plaintiff receives third party financing for litigation.

Keywords: settlement-litigation decision, costs of bargaining, non-bargaining, delegation of dispute resolution, risks of litigation, plaintiff-characteristic dependence,low plaintiff win rates

JEL Classification: C78, D74, D86, K41

November 2010

Full text in pdf format:

346.pdf

Infinitely Repeated Games with Public Monitoring and Monetary Transfers

Abstract:

In this paper, we study infinitely repeated games with imperfect public monitoring and the possibility of monetary transfers. We develop an effcient algorithm to compute the set of pure strategy public perfect equilibrium payoffs for each discount factor. We also show how all equilibrium payoffs can be implemented with a simple class of stationary equilibria that use stick-and-carrot punishments.

July 2010

Full text in pdf format:

332.pdf

Using Forward Contracts to Reduce Regulatory Capture

Abstract:

A fully unbundled, regulated network firm of unknown efficiency level can untertake unobservable effort to increase the likelihood of low downstream prices, e.g. by facilitating downstream competition. To incentivize such effort, the regulator can use an incentive scheme paying transfers to the firm contingent on realized downstream prices. Alternatively, the regulator can force the firm to sell the following forward contracts: the firm pays the downstream price to the owners of a contract, but recieves the expected value of the contracts when selling them to a competivitve financial market. We compare the two regulatory tools with respect to regulatory capture: if the regulator can be bribed to suppress information on the underlying state of the world (the basic propability of high downstream prices, or the type of the firm), optimal regulation uses forward contracts only.

Keywords: incentive regulation, regulatory capture, virtual power plants

JEL Classification: L42, L51, K23, L94

February 2010

Full text in pdf format:

320.pdf

Optimal Procurement Contracts with Pre–Project Planning

Abstract:

The paper studies procurement contracts with pre–project investigations in the presence of adverse selection and moral hazard. To model the procurer’s  roblem, we extend a standard sequential screening model to endogenous information acquisition with moral hazard. The optimal contract displays systematic distortions in information acquisition. Due to a rent effect, adverse selection induces too much information acquisition to prevent cost overruns and too little information acquisition to prevent false project cancelations. Moral hazard mitigates the distortions related to cost overruns yet exacerbates those related to false negatives. The optimal mechanism is a menu of option contracts that achieves the dual goal of providing incentives for information acquisition and truthful information revelation.

Keywords: Information acquisition, procurement, dynamic mechanism design
JEL Classification: D82, H57

January 2010

Full text in pdf format:

303.pdf

On and Off Contract Remedies

Abstract:

A party dissatisfied with the contractual performance of a counterparty is typically able to pursue a variety of legal recourses. Within this apparent variety lurk two fundamental alternatives. The aggrieved party may (i) “affirm” the contract and seek money damages or specific performance; or (ii) “disaffirm” the contract with the remedy of rescission and restitution. This simple dichotomy of contract remedies applies broadly in both common law and civil law practice. We show here that this remedial regime allows parties to write simple contracts that induce first-best cooperative investments.

Keywords: breach remedies, incomplete contracts, cooperative investments.
JEL Classification: K12, L22, J41, C70.

December 2009

Full text in pdf format:

290.pdf

Insolvency and Biased Standards - The Case for Proportional Liability

Abstract:

We analyze liability rules in a setting where injurers are potentially insolvent and where negligence standards may deviate from the socially optimal level. We show that proportional liability, which sets the measure of damages equal to the harm multiplied by the probability that it was caused by an injurer’s negligence, is preferable to other existing negligence-based rules. Moreover, proportional liability outperforms strict liability if the standard of due care is not set too low. Our analysis also suggests that courts should rely on statistical evidence and bar individualized causal claims that link the harm suffered by a plaintiff to the actions of the defendant. Finally, we provide a result which might be useful to regulators when calculating minimum capital requirements or minimum mandatory insurance for different industries.

 
Keywords: judgment proof problem, uncertain causation, court error and misperception, proportional liability, disgorgement

JEL Classification: K13

December 2009

Full text in pdf format:

289.pdf

Breach Remedies Including Hybrid Investments

Abstract:

We show that parties in bilateral trade can rely on the default common law breach remedy of  ‘expectation damages’ to induce simultaneously first-best relationship-specific investments of both the selfish and the cooperative kind. This can be achieved by writing a contract that specifies a suffciently high quality level. In contrast, the result by Che and Chung (1999) that ‘reliance damages’ induce the firstbest in a setting of purely cooperative investments, does not generalize to the hybrid case. We also show that if the quality specified in the contract is too low, ‘expectation damages’ do not necessarily induce the ex-post effcient trade decision in the presence of cooperative investments.

Keywords: breach remedies, incomplete contracts, hybrid investments, cooperative investments, selfish investments

JEL Classification: K12, L22, J41, C70

October 2009

Full text in pdf format:

282.pdf

Signaling an Outside Option

Abstract:

We consider the case of an upstream seller who works to
improve an asset that has been specialized to a downstream buyer's needs. The buyer then makes a take it or leave it offer to the seller about how the future surplus should be split. We assume that the seller from the outset has private information about the fraction of the surplus that he can realize on his own, and show that this leads to higher investment compared to the complete information case. This positive effect on investment is countervailed by the occurrence of inefficient separations, which result when the buyer mistakenly tries to call the seller's bluff with a low offer.

Keywords: signaling, relationship-specific investment, incomplete contracts, outside options

JEL Classification:D23, D82

October 2009

Full text in pdf format:

281.pdf

Nationalizations and effciency

Abstract:

We develop a theoretical model in which firms are either private or state-owned. When firms become insolvent, the government can intervene with general measures, like subsidies, or by nationalizing firms. The government only intervenes when the bankruptcy of a firm entails social costs. In a stylized model, we analyze how government interventions affect allocative and productive efficiency. Nationalization of private firms in case unprofitable investments were made, leads to increased allocative efficiency despite private ownership. The effort level chosen by the managers working for firms is also affected by government intervention with an impact on productive efficiency.

Keywords: nationalization, efficiency

JEL Classification: L33, P31, P51

July 2009

Full text in pdf format:

268.pdf

Renegotiation-Proof Relational Contracts with Side Payments

Abstract:

We study infinitely repeated two player games with perfect information, where each period consists of two stages: one in which the parties simultaneously choose an action and one in which they can transfer money to each other. We first derive simple conditions that allow a constructive characterization of all Pareto-optimal subgame perfect payoffs for all discount factors. Afterwards, we examine different concepts of renegotiation-proofness and extend the characterization to renegotiation-proof payoffs.

Keywords: renegotiation, infinitely repeated games, side payments, optimal penal codes

JEL Classification: C73, L14

April 2009

Full text in pdf format:

259.pdf

Breach Remedies, Performance Excuses, and Investment Incentives

Abstract:

Contract law is usually perceived as a strict liability system. When a promisor fails to perform he is held liable even if he is without fault. If, however, an unusual contingency has arisen he may be excused from performing provided that he has taken reasonable precautions. For a setting with uncertain costs of and benefits from performance, it is shown that a fixed price contract is sufficient to generate efficient reliance and precautions incentives under the following legal regime. If the promisor has met the appropriate precaution standard then he is excused if performance fails to be profitable. Alternative regimes, in contrast, where he is excused if performance is inefficient or even is extremely costly distort investment incentives quite generally.

Keywords: performance excuse, impracticability doctrine, overreliance, efficient precaution
JEL Classification: K12
September 2008

Full text in pdf format:

247.pdf

Standard Breach Remedies, Quality Thresholds, and Cooperative Investments

Abstract:

When investments are non-verifiable, inducing cooperative investments with simple contracts may not be as difficult as previously thought. Indeed, modeling 'expectation damages' close to legal practice, we show that the default remedy of contract law induces the first best. Yet, in order to lower informational requirements of courts, parties may opt for a 'specific performance' regime which grants the breached-against buyer an option to choose 'restitution' if the tender's value falls below some (exogenously given) quality threshold. In order to implement this regime, no more information needs to be verifiable than is implicitly assumed in Che and Hausch (1999).

Keywords: breach remedies, imcomplete contracts, cooperative investments
JEL Classification: K12, L22, J41, C70
July 2008

Full text in pdf format:

242.pdf

Centralized and decentralized provision of public goods

Abstract:

We model the trade-off between centralized and decentralized decision making over the provision of local public goods. Centralized decisions are made in a legislature of locally elected representatives, and this creates a conflict of interest between citizens in different jurisdictions. The legislature can be self-interested or benevolent and this can result in either efficient, excessive or misallocative provision of public goods. Decisions are inuenced by spillover effects and differences in jurisdictionalsize. Furthermore, we look at the incentives for centralization.

Keywords: decentralization, local public goods
JEL Classification: H40, H70, P51
July 2008

Full text in pdf format:

241.pdf

Legal Damages for Losses of Chances

Abstract:

This paper deals with legal damages if losses of chances are at stake. In response to disparate ad hoc rules that have emerged from legal practice in Europe, the present paper proposes a unifying principle to handle such cases. Quite generally, the purpose of a damages award is to compensate the claimant and should be based on the difference in value between due performance and actual performance. To cope with limited observability, it is suggested to still award the difference though on average over the observed event. The paper calculates damages in line with this general principle. The proposed damage scheme is shown to fully compensate the victim and to provide efficient incentives for precaution, be it that multiple injurers act non-cooperatively or in concert, even if losses of chances are at stake.

Keywords: estimating legal damages, liability for torts, liability for breach of contracts, uncertain causation,difference hypothesis
JEL classification: K12, K13, D62
February 2008

Full text in pdf format:

235.pdf

Expectation Damages, Divisible Contracts, and Bilateral Investment

Abstract:

This paper examines the efficiency of expectation damages as a breach remedy in a bilateral trade setting with renegotiation and relationship-specific investment by the buyer and the seller. As demonstrated by Edlin and Reichelstein (1996), no contract that specifies only a fixed quantity and a fixed per-unit price can induce efficient investment if marginal cost is constant and deterministic. We show that this result does not extend to more general payoff functions. If both parties face the risk of breaching, the first best becomes attainable with a simple price-quantity contract.

Keywords: breach remedies, renegotiation, hold-up
JEL classification: K12, D86, L14
March 2008

Full text in pdf format:

231.pdf

Opportunistic Termination

Abstract:

If a seller delivers a good non-conforming to contract, European and US warranty law allows consumers to choose between some money transfer and termination. Termination rights are, however, widely criticized, mainly for fear that the buyer may use non-conformity as a pretext for getting rid of a contract he no longer wants. We show that this possibility of 'opportunistic termination' might actually have positive effects. Under some circumstances, it will lead to redistribution in favour of the buyer without any loss of efficiency. Moreover, by curbing the monopoly power of the seller, a regime involving termination might increase welfare by enabling a more efficient output level in a setting with multiple buyers.

Keywords: contract law, warranties, breach remedies, termination, harmonization
JEL classification: K12, C7, L40, D30
August 2008

Full text in pdf format:

226_01.pdf

Plaintiffs exploiting Plaintiffs

Abstract:

We consider a model of a single defendant and N plaintiffs where the total cost of litigation is fixed on the part of the plaintiffs and shared among the members of a suing coalition. By settling and dropping out of the coalition, a plaintiff therefore creates a negative externality on the other plaintiffs. It was shown in Che and Spier (2007) that failure to internalize this externality can often be exploited by the defendant. However, if plaintiffs make sequential take-it-or-leave-it settlement offers, we can show that they will actually be exploited by one of their fellow plaintiffs rather than by the defendant. Moreover, if litigation is a public good as is the case in shareholder derivative suits, parties may fail to reach a settlement even having complete information. This may explain why we observe derivative suits in the US but not in Europe.

Keywords: litigation, settlement, bargaining, contracting with externalities, derivative suits, public goods
JEL classification: K41, C7, H4
January 2008

Full text in pdf format:

224.pdf

Does Interbank Borrowing Reduce Bank Risk?

Abstract:

In this paper we investigate whether banks that borrow from other banks have lower risk levels. We concentrate on a large sample of Central and Eastern European banks which allows us to explore the impact of interbank lending when exposures are long-term and interbank borrowers are small banks. The results of the empirical analysis generally confirm the hypothesis that long-term interbank exposures result in lower risk of the borrowing banks.

Keywords: interbank market, bank risk, market discipline, transition countries
JEL classification: G21, E53
November 2007

Full text in pdf format:

223.pdf

Country size and publicly provided goods

Abstract:

This paper studies the equilibrium size of countries. Individuals in small countries have greater influence over the nature of political decision making while individuals in large countries have the advantage of more public goods and lower tax rates. The model implies that (i) there exists excessive incentives to separate, though this need not be the case for all sets of secession rules studied; (ii) an exogenous increase in public spending decreases country size; (iii) countries with a presidential-congressional democracy are larger than countries with a parliamentary democracy.

Keywords: country size, public spending, structure of government
JEL classification: D7, H1, H2, H7
December 2006

Full text in pdf format:

187.pdf

Size and soft budget constraints

Abstract:

There is much evidence against the so-called "too big to fail" hypothesis in the case of bailouts to sub-national governments. We look at a model where districts of different size provide local public goods with positive spillovers. Matching grants of a central government can induce socially-efficient provision, but districts can still exploit the intervening central government by inducing direct financing. We show that the ability of a district to induce a bailout from the central government and district size are negatively correlated.

Keywords: bailouts, soft-budget constraints, jurisdictional size, public goods, spillovers
JEL Classification: H4, H7, R1
October 2006

Full text in pdf format:

172.pdf

Reliance Investments, Expectation Damages and Hidden Information

Abstract:

A setting of reliance investments is explored where one of the parties to a contract obtains private information concerning his utility or cost function that remains hidden to the other party and to courts. As a consequence, it will be a difficult task to award expectation damages corrrectly to a party with private information who sufffers from breach of contract. While a revelation mechanism would exist that leads to the first best solution, assessing expectation damages correctly turns out to be at odds with ex post efficiency. I conclude that, under asymmetric information, the performance of expectation damages falls short of what more general mechanisms could achieve.

Keywords: reliance investments, expectation damages, breach of contract, hidden information
JEL classification: K12, D82
September 2006

Full text in pdf format:

162.pdf

Legal Damages at Uncertain Causation

Abstract:

The legal notion of damages requires to compare the actual value of the creditor’s assets with the hypothetical value that would have prevailed if the debtor had met his obligation. Moreover, values and causation may be uncertain. If nature’s contribution is modelled as a random move then the interaction between debtor and nature can be described in normal form which, in turn, allows to capture causality and legal damages in a consistent way. In practice, such random moves of nature are rarely observable. Yet, statistical inference may reveal sufficient information to test for causation and to estimate legal damages on average over observable events as the present paper will establish.

Keywords: estimating legal damages, liability for torts, liability for breach of contracts
JEL Classification: K13, K12, D62
August 2006

Full text in pdf format:

160.pdf

Sovereign Risk Premiums in the European Government Bond Market

Abstract:

This paper provides a study of bond yield differentials among EU government bonds issued between 1993 and 2005 on the basis of a unique dataset of issue spreads in the US and DM (Euro) bond market. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premiums which increase with fiscal imbalances and depend negatively on the issuer's relative bond market size. The start of the European Monetary Union has shifted market attention to debt service payments as the key measure of indebtedness and eliminated liquidity premiums in the euro area.

Keywords: asset pricing, determination of interest rates, fiscal policy, government debt
JEL Classification: G12, E43, E62, H63
May 2006

Full text in pdf format:

151.pdf

The design of fiscal rules and forms of governance in European Union countries

Abstract:

This paper uses a new data set on budgetary institutions in Europe to examine the impact of fiscal rules and budget procedures in EU countries on public finances. It briefly describes the main pattern of budgetary institutions and their determinants across the EU 15 member states. Empirical evidence for the time period 1985-2004 suggests that the centralisation of budgeting procedures restrains public debt. In countries with one-party governments or coalition governments where parties are closely aligned and where political competition among them is low, this is achieved by the delegation of decision-making power to the minister of finance. Fiscal contracts that require countries to set multi-year targets and that reinforce those targets increase fiscal discipline in countries with ideologically dispersed coalitions and where parties regularly compete against each other.

Keywords: public indebtedness, budgetary procedures, fiscal rules, European public finances
JEL Classification: H11, H61, H62
June 2006

Full text in pdf format:

150.pdf

Political Economy of Fiscal Institutions

Abstract:

We discuss two essential problems of the political economy of public finances: The principal agent problem between voters and elected politicians and the common pool problem arising from the fact that money drawn from a general tax fund is used to pay for policies targeting more or less narrow groups in society. Three institutional mechanisms exist to deal with these problems, ex-ante rules controlling the behavior of elected policy makers, electoral rules creating accountability of and competition among policy makers, and budgeting processes internalizing the common pool externality. We review recent theoretical and empirical research and discuss its implications for research and institutional design.

Keywords: electoral systems, fiscal rules, budgeting processes
JEL Classification: H11, H61, H62
November 2005

Full text in pdf format:

149.pdf

What do deficits tell us about debt? Empirical evidence on creative accounting with fiscal rules in the EU

Abstract:

Fiscal rules, such as the Excessive Deficit Procedure and the Stability and Growth Pact (SGP), aim at constraining government behavior. Milesi-Ferretti (2003) develops a model in which governments circumvent such rules by reverting to creative accounting. The amount of this depends on the reputation cost for the government and the economic cost of sticking to the rule. We provide empirical evidence of creative accounting in the European Union. We find that the SGP rules have induced governments to use stock-flow adjustments, a form of creative accounting, to hide deficits. The tendency to substitute stock-flow adjustments for budget deficits is especially strong for the cyclical component of the deficit, as in times of recession the cost of reducing the deficit is particularly large.

Keywords: Fiscal rules, stock-flow adjustments, debt-deficit adjustments, stability and growth pact, excessive deficit procedure, ESA 95
JEL Classification: E62, H61, H62, H 63, H 70
January 2006

Full text in pdf format:

148.pdf

Fiscal Rules and Fiscal Performance in the EU and Japan

Abstract:

Fiscal rules specify quantitative targets for key budgetary aggregates. In this paper, we review the experience with such rules in Japan and in the EU. Comparing the performance of fiscal policy in the 1980s and 1990s until 2003, we find that the fiscal rule of the 1980s exerted some but not much disciplinary influence on Japanese fiscal policy. The fiscal rule of the Maastricht Treaty had a significant impact on political budget cycles in the EU, but did little to constrain fiscal policy in the large member states. Since the start of the European Monetary Union, the disciplinary effect of the fiscal rule in the EU has vanished. Next, we discuss the importance of budgetary institutions for the effectiveness of fiscal rules. In Europe, a number of countries adopted strong fiscal rules, i.e., a fiscal rule combined with a design of the budget process enabling governments to commit to the rule. We find that strong fiscal rules have been effective. We conclude with some suggestions for the design of a strong fiscal rule in Japan.

Keywords: Fiscal policy, political budget cycles, government budgeting
JEL Classification: H11, H61, H62
June 2006

Full text in pdf format:

147.pdf

Budget Processes: Theory and Experimental Evidence

Abstract:

This paper studies budget processes, both theoretically and experimentally. We compare the outcomes of bottom-up and top-down budget processes. It is often presumed that a top-down budget process leads to a smaller overall budget than a bottom-up budget process. Ferejohn and Krehbiel (1987) showed theoretically that this need not be the case. We test experimentally the theoretical predictions of their work. The evidence from these experiments lends strong support to their theory, both at the aggregate and the individual subject level.

Keywords: Budget processes, voting equilibrium, experimental economics
JEL Classification: H61, C91, C92
March 2006

Full text in pdf format:

146.pdf

Failure to Delegate and Loss of Control

Abstract:

This paper provides an explanation for the frequently observed phenomenon of “inefficient micromanagement”. I show that a supervisor may get comprehensively involved into activities of a subordinate although a better option of delegation is available. This inefficiency persists in the absence of conflict of preferences and even as the cost of delegation becomes zero. The paper also demonstrates that imposing constraints on communication with a subordinate can be beneficial for a superior.

October 2004

Full text in pdf format:

130.pdf

Veto-Based Delegation

Abstract:

In a principal-agent model with hidden information and no monetary transfers, I establish the Veto-Power Principle: any incentive-compatible outcome can be implemented through veto-based delegation with an endogenously chosen default decision. This result demonstrates the exact nature of commitment powers required by the principal: (1) to design the default outcome and (2) to ensure that she has almost no formal control over the agent's decisions.

Keywords: veto power, asymmetric information, principal-agent relationship, no monetary transfers.
JEL Classification: D78, D82, L22, M54
January 2005

Full text in pdf format:

129.pdf

A Characterization of the Conditions for Optimal Auction with Resale

Abstract:

Zheng has proposed a seller-optimal auction for (asymmetric) independent-privatevalue environments where inter-bidder resale is possible. Zheng’s construction requires novel conditions — Resale Monotonicity, Transitivity, and Invariance — on the bidders’ value distribution profile. The only known examples of distribution profiles satisfying these conditions in environments with three or more bidders are uniform distributions. Our characterization result shows that Zheng’s conditions, while being strong, are satisfied by many non-uniform distribution profiles. A crucial step in our analysis is to show that Invariance implies Resale Monotonicity and Transitivity.

Keywords: independent private values, optimal auction, resale, inverse virtual valuation function
May 2006

Full text in pdf format:

128.pdf

First-mover disadvantage

Abstract:

This note considers a bargaining environment with two-sided asymmetric information and quasilinear preferences in which parties select bargaining mechanism after learning their valuations. I demonstrate that sometimes the buyer achieves a higher ex-ante payoff if the bargaining mechanism is selected by her opponent rather than by herself. In the model, the buyer has limited wealth and in addition to acquiring one good from the seller can purchase a different good from a competitive market. The positive relation between the values of these goods is what delivers our result.

JEL Classification: C72, C78, D82
October 2005

Full text in pdf format:

127.pdf

Tortious Acts Affecting Markets

Abstract:

The present paper examines an injurer causing a temporary blackout to a firm as the primary victim but also affecting customers and competitors of the firm. Reflecting existing legal practice, the paper investigates efficiency properties of the negligence rule granting recovery of private losses but to the primary victim only. The regime is shown to provide efficient incentives for precaution provided that the primary loss exceeds the social loss from accidents. The main contribution of the paper consists of an explicit analysis of markets affected by a temporary blackout of one firm. The analysis reveals that the private loss exceeds the social loss indeed if the market is less than fully competitive. Moreover, the net social loss remains positive, no matter which market structure prevails.

JEL Classification: K13, K12, D62
April 2006

Full text in pdf format:

106.pdf

Incentives for separation and incentives for public good provision

Abstract:

In this paper I examine the incentives of regions to unite, to separate and to provide public goods. Separation allows for greater influence over the nature of political decision making while unification allows regions to exploit economies of scale in the provision of public goods. When public good provision is relatively inexpensive, separation occurs since individuals want to assert greater influence, while for intermediate costs of public good provision, separation can be explained by the desires for greater influence as well as for more public goods. Compared with the social optimum, there are excessive incentives for public good provision as well as excessive incentives for separation.

Keywords: unification, separation, public good provision, voting
JEL Classification: D7, H2, H7
March 2006

Full text in pdf format:

104.pdf

Local Public Good Provision, Municipal Consolidation, and National Transfers

Abstract:

We analyze a simple model of local public good provision in a country consisting of a large number of heterogeneous regions, each comprising two districts, a city and a village. When districts remain autonomous and local public goods have positive spillover effects on the neighboring district, there is underprovision of public goods in both the city and the village. When districts consolidate, underprovision persists in the village (and may even become more severe), whereas overprovision of public goods arises in the city as urbanites use their political power to exploit the villagers. From a social welfare point of view, inhabitants of the village have insufficient incentives to vote for consolidation. We examine how national transfers to local governments can resolve these problems.

Keywords: local public goods, municipal consolidation, voting, intergovernmental transfers
JEL Classification: D7, H2, H7, R5
January 2006

Full text in pdf format:

86.pdf

War with Outsiders Makes Peace Inside

Abstract:

In many situations there is a potential for conflict both within and between groups. Examples include wars and civil wars and distributional conflict in multitiered organizations like federal states or big companies. This paper models such situations with a logistic technology of conflict. If individuals decide simultaneously and independently about the amount of internal conflict, external conflict and production, there is typically either only internal conflict, or only external conflict - but not both. If each group decides collectively how much each member has to put into the external conflict before the members individually decide on the amounts put into the internal conflict and production, groups choose sufficiently high external conflict in order to avoid internal conflict. This is a model of the "diversionary use of force". We also study the optimal number of groups.

Keywords: conflict, war, rent-seeking, hierarchy, federalism, diversion
JEL Classification: D72, D74, H11, H74
December 2005

Full text in pdf format:

75.pdf

Black Sheep and Walls of Silence

Abstract:

In this paper we analyze the frequently observed phenomenon that (i) some members of a team (“black sheep”) exhibit behavior disliked by other (honest) team members, who (ii) nevertheless refrain from reporting such misbehavior to the authorities (they set up a “wall of silence”). Much cited examples include hospitals and police departments. In this paper, these features arise in equilibrium. An important ingredient of our model are benefits that agents receive when cooperating with each other in a team. Our results suggest that teams in which the importance of these benefits varies across team members are especially prone to the above mentioned phenomenon.

Keywords: teams, misbehavior, wall of silence, asymmetric information
JEL classification: D82, C73
June 2005

Full text in pdf format:

56.pdf

Cooperative Investments Induced by Contract Law

Abstract:

Lecture on the first SFB/TR 15 meeting, Gummersbach, July, 18 - 20, 2004

This paper revisits the economic analysis of contract law for a setting of cooperative investments. While Che and Chung (1999) have shown that expectation damages perform rather poorly, the present paper argues that this negative result follows from their impicit assumption of unilateral expectation damages. Yet, the very nature of cooperative investments gives rise to the possibility that both parties may claim expectation damages. It is shown that such a regime of bilateral expectation damages provides the incentives for the first best solution even in a framework of binary choice where, for selfish investments, the traditional overreliance result would hold.

JEL Classification: K12, D62
June 2004

Full text in pdf format:

10.pdf

Herding and Contrarian Behavior in Financial Markets - An Internet Experiment

Abstract:

Lecture on the first SFB/TR 15 meeting, Gummersbach, July, 18 - 20, 2004

We report results of an internet experiment designed to test the theory of informational cascades in financial markets (Avery and Zemsky, AER, 1998). More than 6400 subjects, including a subsample of 267 consultants from an international consulting firm, participated in the experiment. As predicted by theory, we find that the presence of a flexible market price prevents herding. However, the presence of contrarian behavior, which can (partly) be rationalized via error models, distorts prices, and even after 20 decisions convergence to the fundamental value is rare. We also report some interesting differences with respect to subjects’ fields of study. Reassuringly, the behavior of the consultants turns out to be not significantly different from the remaining subjects.

Keywords: informational cascades, herding, contrarians, experiment, internet
JEL Classification: C92, D8, G1
June 2004

Full text in pdf format:

7.pdf