Discussion Papers

Delegation and Communication

Abstract:

This paper analyzes delegation and joint decision making in an environment with private information and partially aligned preferences. We compare the benefits of these two decision making procedures as well as the interaction between them. We give a condition under which delegation is preferred to ex post joint decision making and we show how the interaction between delegation and ex post joint decision making always crowds out delegation. Finally, we analyze how the availability of the principal at the communication stage affects our results.

JEL classification: D23, D82, L23

Full text in pdf format:

524SFB.pdf

Repeated Implementation

Abstract:

We prove that a social choice function is repeatedly implementable if and only if it is dynamically monotonic when the number of agents is at least three. We show how to test dynamic monotonicity by building an associated repeated game. It follows that a weaker version of Maskin monotonicity is necessary and sufficient among the social choice functions that are efficient. As an application, we show that utilitarian social choice functions, which can only be one-shot implemented with side-payments, are repeatedly implementable, as continuation payoffs can play the role of transfers. Under some additional assumptions, our results also apply when the number of agents is two.

JEL classification: C73, D71
Keywords: Mechanism Design, Dynamic Monotonicity, Efficiency, Repeated Implementation, Repeated Games, Approximation of the Equilibrium Set, Sufficient and Necessary Condition

Full text in pdf format:

518SFB.pdf

Believing when Credible: Talking about Future Plans and Past Actions

Abstract:

We explore in an equilibrium framework whether games with multiple Nash equilibria are easier to play when players can communicate. We consider two variants, modelling talk about future plans and talk about past actions. The language from which messages are chosen is endogenous, messages are allowed to be vague. We focus on equilibria where messages are believed whenever possible, thereby develop a theory of credible communication. Predictions confirm the longstanding intuition for Aumann’s (1990) Stag Hunt game which applies directly to an investment game with positive spillovers. Our results shed new light on the multiplicity of equilibria in economic applications.

JEL classification: C72, D83
Keywords: Pre-Play Communication, Cheap Talk, Credibility, Coordination, Language, Multiple Equilibria.

Full text in pdf format:

517SFB.pdf

Credence Goods, Costly Diagnosis, and Subjective Evaluation

Abstract:

We study contracting between a consumer and an expert. The expert can invest in diagnosis to obtain a noisy signal about whether a low–cost service is sufficient or whether a high–cost treatment is required to solve the consumer’s problem. This involves moral hazard because diagnosis effort and signals are not observable. Treatments are contractible, but success or failure of the low–cost treatment is observed only by the consumer. Payments can therefore not depend on the objective outcome but only the consumer’s report, or subjective evaluation. A failure of the low–cost treatment delays the solution of the consumer’s problem by the high–cost treatment to a second period. We show that the first–best solution can always be implemented if the parties’ discount rate is zero; an increase in the discount rate reduces the range of parameter combinations for which the first–best can be obtained. In an extension we show that the first–best is also always implementable if diagnosis and treatment can be separated by contracting with two different agents.

Keywords: credence goods, information acquisition, moral hazard, subjective evaluation
JEL Classification No.: D82, D83, D86, I11,

Full text in pdf format:

483_01.pdf

Signaling Competence in Elections

Abstract:

We analyze how political candidates can signal their competence and show that polarization might be a way of doing this. For this purpose, we study a unidimensional Hotelling-Downs model of electoral competition in which a fraction of candidates have the ability to correctly observe a policy-relevant state of the world. We show that candidates tend to polarize, even in the absence of policy bias. This is because proposing an extreme platform has a competence signaling effect and has a strictly higher probability of winning than proposing a median platform. The degree of polarization depends on how uncertain is the state of the world.

Full text in pdf format:

442.pdf

Commitments, Intentions, Truth and Nash Equilibria

Abstract:

Games with multiple Nash equilibria are believed to be easier to play if players can communicate. We present a simple model of communication in games and investigate the importance of when communication takes place. Sending a message before play captures talk about intentions, after play captures talk about past commitments. We focus on equilibria where messages are believed whenever possible. Applying our results to Aumann’s Stag Hunt game we find that communication is useless if talk is about commitments, while the efficient outcome is selected if talk is about intentions. This confirms intuition and empirical findings in the literature.

We develop a theory of credible communication under complete information and connect it to the notion of credibility in standard senderreceiver games.

Keywords: Pre-play communication, cheap talk, credibility, coordination, sender-receiver games.

JEL Classification Numbers: C72, D83.

Full text in pdf format:

438.pdf

Mechanism Design by an Informed Principal: The Quasi- Linear Private-Values Case

Abstract:

We show that, in environments with independent private values and transferable utility, a privately informed principal can implement a contract that is ex-ante  optimal for her. As an application, we consider a bilateral exchange environment (Myerson and Satterthwaite, 1983) in which the principal is one of the traders. If the property rights over the good are dispersed among the traders, the principal will implement a contract in which she is almost surely better off than if there were no uncertainty about her information. The optimal contract is a combination of a participation fee, a buyout option for the principal, and a resale stage with posted prices and, hence, is a generalization of the posted price that would be optimal if the principal's valuation were commonly known. We also provide a condition under which the principal implements the same contract regardless of whether the agents know her information or not.

Full text in pdf format:

437.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

Signalling Rivalry and Quality Uncertainty in a Duopoly

Abstract:

This paper considers price competition in a duopoly with quality uncertainty. The established firm (the `incumbent') offers a quality that is publicly known; the other firm (the `entrant') offers a new good whose quality is not known by some consumers. The incumbent is fully informed about the entrant's quality. This leads to price signalling rivalry because the incumbent gains and the entrant loses if observed prices make the uninformed consumers more pessimistic about the entrant's quality. When the uninformed consumers' beliefs satisfy the `intuitive criterion' and the `unprejudiced belief refinement', prices signal the entrant's quality only in a two-sided separating equilibrium and are identical to the full information outcome.

Keywords: Quality uncertainty, Signalling, Oligopoly, Price competition

JEL Classification No.: D43, D82, L15

Full text in pdf format:

400_01.pdf

Subjective Evaluation versus Public Information

Abstract:

This paper studies a principal-agent relation in which the principal's private information about the agent's effort choice is more accurate than a noisy public performance measure. For some contingencies the optimal contract has to specify ex post inefficiencies in the form of inefficient termination (firing the agent) or third-party payments (money burning). We show that money burning is the less efficient incentive device: it is used at most in addition to firing and only if the loss from termination is small. Under an optimal contract the agent's wage may depend only on the principal's report and not on the public signal. Nonetheless, public information is valuable as it facilitates truthful subjective evaluation by the principal.

Keywords: Subjective evaluation, moral hazard, termination clauses, third-party payments

JEL Classification No.: D23, D82, D86, J41, M12

Full text in pdf format:

399.pdf

The Timing of Climate Agreements under Multiple Externalities

Abstract:

We study the potential of cooperation in global emission abatements with multiple externalities. Using a two-country model without side-payments, we identify the strategic effects under different timing regimes of cooperation. We obtain a positive complementarity effect of long-term cooperation in abatement on R&D levels that boosts potential benefit of long-term cooperation and a redistributive effect that destabilizes long-term cooperation when countries are asymmetric. We show that whether and what type of cooperation is sustainable, depends crucially on the kind rather than on the magnitude of asymmetries.

Keywords: climate treaty; timing of cooperation; multiple externalities; long-term commitment

JEL classification: D62, F53, H23, Q55

November 2011

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366.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

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363.pdf

Two-sided Certification: The market for Rating Agencies

Abstract:

Certifiers contribute to the sound functioning of markets by reducing a symmetric information. They, however, have been heavily criticized during the 2008-09 financial crisis. This paper investigates on which side of the market a monopolistic profit-maximizing certifier offers his service. If the seller demands a rating, the certifier announces the product quality publicly, whereas if the buyer requests a rating it remains his private information. The model shows that the certifier offers his service to sellers and buyers to maximize his own profit with a higher share from the sellers. Overall, certifiers increase welfare in specific markets. Revenue shifts due to the financial crisis are also explained.

Keywords: Certification, Rating Agencies, Asymmetric Information, Financial Markets.
JEL Classification: G14, G24, L15, D82.

October 2010

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338.pdf

Information sharing in contests

Abstract:

We study the incentives to share private information ahead of contests, such as markets with promotional competition, procurement contests, or R&D. We consider the cases where firms have (i) independent values and (ii) common values of winning the contest. In both cases, when decisions to share information are made independently, sharing information is strictly dominated. With independent values, an industry-wide agreement to share information can arise in equilibrium. Expected effort is lower with than without information sharing. With common values, an industry-wide agreement to share information never arises in equilibrium. Expected effort is higher with than without information sharing.

Keywords: information sharing; contest; all-pay auction
JEL Classification: D82; D43; D44; L13; D74

September 2010

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334.pdf

Separating Equilibria with Imperfect Certification

Abstract:

Viscusi (1978) shows how, in markets with quality uncertainty, perfect certification results in separation from top down due to an unraveling process similar to Akerlof (1970). De and Nabar (1991) argue that imperfect certification prevents unraveling so that equilibria with full separation do not exist. This note shows that, if one considers the buyers' buying decision explicitly, a separating equilibrium with imperfect certification does exist.

Keywords: certification, unraveling, separating equilibrium
JEL Classification: D82, L15

June 2010

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324.pdf

Who Should Pay for Certification?

Abstract:

Who does, and who should initiate costly certification by a third party under asymmetric quality information, the buyer or the seller? Our answer — the seller — follows from a non–trivial analysis revealing a clear intuition. Buyer–induced certification acts as an inspection device, whence seller–induced  certification acts as a signalling device. Seller–induced certification maximizes the certifier’s profit and social welfare. This suggests the general principle that certification is, and should be induced by the better informed party. The results are reflected in a case study from the automotive industry, but apply also to other markets – in particular the financial market.

Keywords: asymmetric information, certification, information acquisition, inspection, lemons, middlemen, signaling

JEL Classification: D40, D82, L14, L15

June 2010

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323.pdf

Mediated Contracts and Mechanism Design

Abstract:

This note relates the mechanisms that are based on mediated contracts of Rahman and Obara (2010) to the mechanisms of Myerson (1982). It shows that the mechanisms in Myerson (1982) are more general in that they encompass the mechanisms based on mediated contracts. It establishes an equivalence between the two classes if mediated contracts are allowed to be stochastic.

Keywords: mediatedcontract, mechanismdesign, revelationprinciple, moralhazard

May 2010

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322.pdf

Hierarchical Structures and Dynamic Incentives

Abstract:

We study the optimal hierarchical structure of an organization under limited commitment. The organization cannot make a long term commitment to wages and output levels, while it can commit to its hierarchical structure. We show that the optimal hierarchical structure is horizontal when it is highly likely that the employees are efficient or inefficient.
By contrast, when such likelihood is intermediate or output does not expand very fast over time, the optimal hierarchical structure is vertical - with a vertical hierarchy, the organization can mitigate dynamic incentive problems linked to limited commitment.

Key words: Dynamic Incentives, Organization Design

JEL Classification: D82, D86

April 2010

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318.pdf

Information acquisition in conflicts

Abstract:

This paper considers incentives for information acquisition ahead of conflicts. First, we characterize the (unique) equilibrium of the all-pay auction between two players with one-sided asymmetric information where one player has private information about his valuation. Then, we use ou rresults to study information acquisition prior to an all-pay auction. If the decision to acquire information is observable, but not the informatio nreceived, one-sided asymmetric information can occur endogenously in equilibrium. Moreover, the cutoff values of the cost of information that determine equilibrium information acquisition are higher  than in the first best.  Thus, information  acquisition is excessive. Incontrast, with open or covert information acquisition,  the equilibrium cut-off values are as in the  first best.

 
Keywords: All-pay auctions; Conflicts; Contests; Information acquisition;
Asymmetric information
JEL Classification: D72; D74; D82; D83

March 2010

Full text in pdf format:

314.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

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303.pdf

Wages and Productivity Growth in a Dynamic Oligopoly

Abstract:

This paper studies the innovation dynamics of an oligopolistic industry. The firms compete not only in the output market but also by engaging in productivity enhancing innovations to reduce labor costs. Rent sharing may generate productivity dependent wage differentials. Productivity growth creates intertemporal spill-over effects, which affect the incentives for innovation at subsequent dates. Over time the industry equilibrium approaches a steady state. The paper characterizes the evolution of the industry's innovation behavior and its market structure on the adjustment path.

Keywords: innovation, laborproductivity, oligopoly, wagedifferentials, productivitygrowth, industrydynamics

JEL Classification: D24, D42, D92, J31

November 2009

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287.pdf

Product Durability in Markets with Consumer Lock-in

Abstract:

This paper examines a two-period duopoly where consumers are locked-in by switching costs that they face in the second period. The paper's main focus is on the question of how the consumer lock-in affects the firms' choice of product durability. We show that firms may face a prisoners' dilemma situation in that they simultaneously choose non-durable products although they would have higher profits by producing durables. From a social welfare perspective, firms may even choose an inefficiently high level of product durability.

Keywords: Consumer Lock-in, Product Durability, Duopoly

JEL Classification: L13, D21

October 2009

Full text in pdf format:

279.pdf

Monopoly Distortions in Durability and Multi-Dimensional Quality

Abstract:

I show that Swan’s (1970) independence result requires a multiplicative interaction between durability and all other quality attributes. Because there is no compelling argument for a multiplicativity in quality, monopolists tend to distort durability, even with constant marginal costs. Distortions in durability and other quality aspects are aligned exactly when the marginal cost of quality do not increase too much with durability.

Keywords: Durability, quality, monopoly
JEL Classification: L15

September 2009

Full text in pdf format:

271.pdf

Sabotage in dynamic tournaments

Abstract:

This paper studies sabotage in a dynamic tournament. Three players compete in two rounds. In the final round, a player who is leading in the race, but not yet beyond the reach of his competitors, gets sabotaged more heavily. As a consequence, if players are at the same position initially, they do not work productively or sabotage at all in the first round. Thus sabotage is not only directly destructive, but also depresses incentives to work productively. If players are heterogeneous ex ante, sabotage activities in the first round may be concentrated against an underdog, contrary to findings from static tournaments. We also discuss the robustness of our results in a less stylized environment.

Keywords: dynamic tournaments, contests, sabotage, heterogeneity

June 2009

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266.pdf

Investments and the Holdup Problem in a Matching Market

Abstract:

This paper studies investment incentives in the steady state of a dynamic bilateral matching market. Because of search frictions, both parties in a match are partially locked–in when they bargain over the joint surplus from their sunk investments. The associated holdup problem depends on market conditions and is more important for the long side of the market. In the case of investments in homogenous capital only the agents on the short side acquire ownership of capital. There is always underinvestment on both sides of the market. But when market frictions become negligible, the equilibrium investment levels tend towards the first–best.

Keywords: Holdup Problem, Matching Market, Investments

JEL Classification: C78, D23, D92

June 2009

Full text in pdf format:

263.pdf

Optional linear input prices in vertical relations

Abstract:

This paper examines how the option of a regulated linear input price affects vertical contracting, where a monopolistic upstream supplier sequentially offers supply contracts to two symmetric downstream firms. We find that equilibrium contracts vary with production cost and regulated price level: If the regulated price is not too high, the option allows for price discrimination, but prevents foreclosure in the intermediary market. Indeed, if both cost and optional price are rather low, non-discriminatory input prices below cost may arise. Optional input prices are socially more desirable than a flat ban on price discrimination, as consumers benefit from more intense downstream competition.

Keywords: price discrimination, vertical contracting, exclusion, regulatory outside option

JEL Classification: D42, L11, L42

April 2009

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258.pdf

Platform Standards, Collusion and Quality Incentives

Abstract:

This paper examines how quality incentives are related to the interoperability of competing platforms. Platforms choose whether to operate standardised or exclusively, prior to quality and subsequent price competition. We find that platforms choose a common standard if they can
coordinate their quality provision. The actual investment then depends on the cost of quality provision: If rather high, platforms refrain from investment; if rather low, platforms maintain vertically differentiated platforms. The latter case is socially more desirable than exclusivity where platforms do not invest. Nevertheless, quality competition of standardised platforms induces the highest investment and maximum welfare.

Keywords: two-sided markets, standards, investment in transaction quality

JEL Classification: D43, D62, L13

January 2009

Full text in pdf format:

257.pdf

Exit Options in Incomplete Contracts with Asymmetric Information

Abstract:

This paper analyzes bilateral contracting in an environment with contractual incompleteness and asymmetric information. One party (the seller) makes an unverifiable quality choice and the other party (the buyer) has private information about its valuation. A simple exit option contract, which allows the buyer to refuse trade, achieves the first–best in the benchmark cases where either quality is verifiable or the buyer’s valuation is public information. But, when unverifiable and asymmetric information are combined, exit options induce inefficient pooling and lead to a particularly simplecontract. Inefficient pooling is unavoidable also under the most general form of contracts, which make trade conditional on the exchange of messages between the parties. Indeed, simple exit option contracts are optimal if random mechanisms are ruled out.

Keywords: Incomplete Contracts, Asymmetric Information, Exit Options
JEL Classification: D82, D86, L15

Novmber 2008

Full text in pdf format:

251.pdf

Collusion and Durability

Abstract:

We develop a model to show that cartels that produce goods with lower durability are easier to sustain implicitly. This observation gen- erates the following results: 1) implicit cartels have an incentive to pro- duce goods with an inefficiently low level of durability; 2) a monopoly or explicit cartel is welfare superior to an implicit cartel; 3) welfare is non-monotonic in the number of firms; 4) a regulator may demand inefficiently high levels of durability to prevent collusion.

Keywords: cartels, collusion, durability
JEL Classification: L15
September 2008

Full text in pdf format:

246.pdf

Can’t Buy Me Rights! The Contractual Structure of Asymmetrical Inter-firm Collaborations

Abstract:

The efficient allocation of control rights in inter-firm collaborations is a widely emphasized issue. In this paper, I empirically identify control rights and the allocation of these rights using a unique survey data set on collaborations between biotechnology and pharmaceutical firms. Fifteen control rights are
identified to make up the structure of deals with five rights being the items of contention in deal making (ownership of patents, production, further development of the technology, the right to manage the collaboration, and the right to market universally). I find that the assignment of control rights is related to the bargaining position of firms and incentive issues. Hence, goliaths –pharmaceutical incumbents
– subrogate critical rights to the new ventures when the final outcome of the project is depending on the venture’s effort.

Keywords: contracts, performance, inter-firm collaboration, biotechnology
JEL Classification: D23, L24, G30, M13, O32

December 2006

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189.pdf

Conflict and the Social Contract

Abstract:

We consider social contracts for resolving conflicts between two agents who are uncertain about each other's fighting potential. Applications include international conflict, litigation, and elections. Even though only a peaceful agreement avoids a loss of resources, if this loss is small enough, then any contract must assign a positive probability of conflict. We show how the likelihood of conflict outbreak depends on the distribution of power between the agents and their information about each other.

Keywords: conflict, social contracts, asymmetric information
JEL Classification: C78, D72, D74, D82, H21, H23.

February 2006

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94.pdf

Advertising and Conspicuous Consumption

Abstract:

The paper formalizes the intuition that brands are consumed for image reasons and that advertising creates a brand’s image. The key idea is that advertising informs the public of brand names and creates the possibility of conspicuous consumption by rendering brands a signalling device. In a price competition framework, we show that advertising increases consumers’ willingness to pay and thus provide a foundation, based on optimization behavior, for persuasive approaches to advertising. Moreover, an incumbent might strategically overinvest in advertising to deter entry, there might be too much advertising, and competition might be socially undesirable.

Keywords: Advertising, Entry Deterrence, Brands, Conspicuous Consumption, Bertrand Competition, All-Pay Auction
JEL Classification: L12, L15, M37

August 2005

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72.pdf

Regret in Dynamic Decision Problems

Abstract:

The paper proposes a framework to extend regret theory to dynamic contexts. The key idea is to conceive of a dynamic decision problem with regret as an intra-personal game in which the agent forms conjectures about the behaviour of the various counterfactual selves that he could have been. We derive behavioural implications in situations in which payoffs are correlated across either time or contingencies. In the first case, regret might lead to excess conservatism or a tendency to make up for missed opportunities. In the second case, behaviour is shaped by the agent’s self-conception. We relate our results to empirical evidence.

Keywords: Regret, Counterfactual Reasoning, Reference Dependence, Information Aversion
JEL Classification: C72, D11, D81

July 2005

Full text in pdf format:

71.pdf

"Download for Free" - When Do Providers of Digital Goods Offer Free Samples?

Abstract:

In a monopoly setting where consumers cannot observe the quality of the product we show that free samples which are of a lower quality than the marketed digital goods are used together with high prices as signals for a superior quality if the number of informed consumers is small and if the difference between the high and the low quality is not too small. Social welfare is higher, if the monopolist uses also free samples as signals, compared to a situation where he is restricted to pure price signalling. Both, the monopolist and consumers benefit from the additional signal.

Keywords: Digital Goods, Free Samples, Multi-dimensional Signalling
JEL classification: D21, D82, L15
September 2004

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70.pdf

Externalities, Communication and the Allocation of Decision Rights

Abstract:

This paper views authority as the right to undertake decisions that impose externalities on other members of the organization. When only decision rights can be contractually assigned to one of the organization’s stakeholders, the optimal assignment minimizes the resulting inefficiencies by giving control rights to the party with the highest stake in the organization’s decisions. Under asymmetric information, the efficient allocation of authority depends on the communication of private information. In the case of multiple decision areas, divided control rights may enhance organizational efficiency unless there exist complementarities between different decisions.

Keywords: Authority, Decision Rights, Externalities, Incomplete Contracts,
Imperfect Information, Theory of the Firm
JEL Classification: D23, D82, L22, P14

November 2005

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69.pdf

Interim Information in Long Term Contracts

Abstract:

This paper studies the effectiveness of interim information in reducing inefficiencies in long term relationships. If the interim information is verifiable, it resolves all problems of asymmetric information. Under nonverifiability, the information alleviates the contracting problem only partially and its optimal use depends on the signal’s accuracy and timing. Precise and early signals enable the principal to extract all rents and adjust allocations closer to the first best. Imprecise or late signals affect only future allocations and leaves the agent with a rent. Due to a failure of the revelation principle, the optimal contract under non–verifiability is derived by employing the theory of communication equilibrium.

Keywords: long term contracts, repeated adverse selection, verifiability, revelation
principle;
JEL Classification: D82

April 2005

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40.pdf

Optimal Information Revelation by Informed Investors

Abstract:

This paper studies the structure of optimal finance contracts in an agency model of outside finance, when investors possess private information. We show that, depending on the intensity of the entrepreneur’s moral hazard problem, optimal contracts induce full, partial, or no revelation of the investor’s private information. A partial or nonrevelation of information is optimal, when it mitigates an undersupply of effort by the entrepreneur due to moral hazard.

Keywords: informed investors, optimal finance contracts, partial information revelation
JEL Classification: G24, D82
January 2005

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34.pdf

Timing of Verification Procedures: Monitoring versus Auditing

Abstract:

This paper studies the strategic effect of a difference in timing of verification in an agency model. A principal may choose between two equally efficient verification procedures: monitoring and auditing. Under auditing the principal receives additional information. Due to a double moral hazard problem, there exists a tension between incentives for effort and incentives for verification. Auditing exacerbates this tension and, consequently, requires steeper incentive schemes than monitoring. Hence, auditing is suboptimal if 1) steep incentives structures are costly to implement due to bounded transfers, or 2) steep incentive schemes induce higher rents due to limited liability. verification in an agency model. A principal may choose between two equally efficient verification procedures: monitoring and auditing. Under auditing the principal receives additional information. Due to a double moral hazard problem, there exists a tension between incentives for effort and incentives for verification. Auditing exacerbates this tension and, consequently, requires steeper incentive schemes than monitoring. Hence, auditing is suboptimal if 1) steep incentives structures are costly to implement due to bounded transfers, or 2) steep incentive schemes induce higher rents due to limited liability.

Keywords: timing of verification, double moral hazard, monitoring, auditi
JEL Classification: D82
January 2005

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33.pdf

Buried in Paperwork: Excessive Reporting in Organizations

Abstract:

This paper offers an explanation why a principal may demand too much paperwork from a subordinate: Due to limited liability and moral hazard a principal is unable to appropriate all rents. Internal paperwork allows a more accurate monitoring of the agent and enables the principal to appropriate a larger part of the agent's rent. In her decision the principal disregards the agent's cost increase of more internal paperwork. Consequently, the requested amount of internal paperwork may be too high from both the agent's personal point of view and the organization as a whole.

JEL Classification: D23, D82
October 2004

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27.pdf

Deterministic versus Stochastic Mechanisms in Principal–Agent Models

Abstract:

This paper shows that, contrary to what is generally believed, decreasing concavity of the agent’s utility function with respect to the screening variable is not sufficient to ensure that stochastic mechanisms are suboptimal. The paper demonstrates, however, that they are suboptimal whenever the optimal deterministic mechanism exhibits no bunching. This is the case for most applications of the theory and therefore validates the literature’s usual focus on deterministic mechanisms.

Keywords: principal-agent theory, mechanism design, deterministic mechanisms, randomization, bunching.
JEL Classification: D82
September 2004

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26.pdf

Honest Certification and the Threat of Capture

Abstract:

This paper derives conditions under which reputation enables certifiers to resist capture. These conditions alone have strong implications for the industrial organization of certification markets: 1) Honest certification requires high prices that may even exceed the static monopoly price. 2) Honest certification exhibits economies of scale and constitutes a natural monopoly. 3) Price competition tends to a monopolization. The results derive from a general principle of reputation models that favors concentration. This principle implies benefits from specialization and explains specialized certifiers as efficient market institutions that sell reputation as a service to other firms.

Keywords: certification, collusion, bribery, reputation, natural monopoly
JEL Classification: L15, D82, L11
August 2004

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25.pdf

Mediation in Situations of Conflict and Limited Commitment

Abstract:

We study the reasons and conditions under which mediation is beneficial when a principal needs information from an agent to implement an action. Assuming a strong form of limited commitment, the principal may employ a mediator who gathers information and makes non-binding proposals. We show that a partial rev-elation of information is more effective through a mediator than through the agent himself. This implies that mediation is strictly helpful if and only if the likelihood of a conflict of interest is positive but not too high. The value of mediation depends non-monotonically on the degree of conflict. Our insights extend to general models of contracting with imperfect commitment.

Keywords: Contracting, Non-Commitment, Revelation Principle
JEL Classification: D82
June 2004

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24.pdf

Externalities and the Allocation of Decision Rights in the Theory of the Firm

Abstract:

This paper views authority as the right to undertake decisions that have external effects on other members of the organization. Because of contractual incompleteness, monetary incentives are insufficient to internalize these effects in the decision maker’s objective. The optimal assignment of decision rights minimizes the resulting inefficiencies. We illustrate this in a principal–agent model where the principal retains the authority to select ‘large’ projects but delegates the decision right to the agent to implement ‘small’ projects. Extensions of the model discuss the role of effort incentives, asymmetric information and multistage decisions.

Keywords: Authority, Control Rights, Decision Rights, Delegation, Externalities, Incomplete Contracts, Theory of the Firm
JEL Classification: D23, D82, L22
April 2004

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23.pdf

Contracting with Imperfect Commitment and Noisy Communication

Abstract:

Lecture on the first SFB/TR 15 meeting, Gummersbach, July, 18 - 20, 2004
This paper provides an analytical framework for studying principal-agent problems with adverse selection and limited commitment. By allowing the principal to use noisy communication we solve two fundamental problems of contracting with imperfect commitment: First, we identify the relevant incentive constraints by showing that only ‘local’ constraints are binding if the agent’s preferences satisfy a single–crossing property. Second, we show that one can restrict the dimensionality of the message spaces of the communication device to the number of the agent’s types. As we illustrate in an example, these findings allow us to derive the optimal contract by a similar procedure as in contracting problems with full commitment.

Keywords: contract theory, communication, imperfect commitment, adverse selection
JEL Classification: D82, C72
December 2003

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