Contract Complexity, Incentives, and the Value of Delegation

In settings where the revelation principle applies, delegation arrangements are frequently inferior to centralized decision making, and at best achieve the same level of performance. This paper studies the value of delegation when organizations are constrained by a bound on the number of contingencies in any contract. For a principal-agent setting with asymmetric information, we compare centralized mechanisms where the principal retains sole responsibility for contracting and coordinating production, with delegation mechanisms where one agent (a manager) is delegated authority to contract with other agents and coordinate production. Relative to centralization, delegation entails a control loss, but allows decisions to be more sensitive to the manager's private information. We identify circumstances under which the flexibility gain outweighs the control loss, so that delegation emerges superior to centralized contracting.     

Indescribability and its irrelevance for contractual incompleteness

The incomplete contracts literature often cites indescribable contingencies as a major obstacle to the creation of complete contracts. Using agents’ minimum foresight concerning possible future payoffs, Maskin and Tirole (Rev Econ Stud 66:83–114, 1999) show that indescribability does not matter for contractual incompleteness as long as there is symmetric information at both the contracting stage and the trading stage. This is called the irrelevance theorem. The following generalization of the irrelevance theorem is shown here: indescribability does not matter even in the presence of asymmetric information at the trading stage, as long as there is symmetric information at the contracting stage. This is an important clarification because Kunimoto (Econ Lett 99:367–370, 2008) shows that indescribability can matter if there is asymmetric information at both stages. It is thus argued that asymmetric information at the contracting stage is necessary for indescribability to be important in the rational agents contracting model.     

Optimal deterministic contracting mechanisms for principal-agent problems with moral hazard and adverse selection

For the principal-agent problem with moral hazard and adverse selection we establish that within the collection of all measurable, deterministic contracting mechanisms satisfying the individual rationality and incentive compatibility constraints there exists one that is optimal for a risk averse principal contracting with a risk averse agent. In addition to demonstrating existence, one of the main contributions of the paper is to show that, in general, centralized contracting implemented via a contracting mechanism is equivalent to delegated contracting implemented via a contract menu. Thus, contracting can always be delegated to the agent without gain or loss to the principal. Based on this result, the existence of an optimal contracting mechanism for the principal-agent problem is established by showing that there exists an optimal contract menu for the equivalent delegated contracting problem. Received: 7 October 1994 / Accepted: 14 January 1997     

Individual contracting,collective bargaining and wages in Australia

We examine wages in Australia under federally registered individual contracts and collective agreements (CAs) using unpublished data from a national earnings survey. The distribution of earnings under registered individual contracts was more unequal than under CAs. Average and median earnings under registered individual contracts were lower than under CAs. There was little evidence that individual contracting raised wages through raising productivity. The link between contracting and pay appears contingent, varying between occupations, industries, and firm size bands and dependent upon employees' position in the labour market and employers' use of union avoidance strategies. This has implications for the interpretation of studies of union wage effects.     

Different Problem,Same Solution: Contract‐Specialization in Venture Capital

Real‐world financial contracts vary greatly in the combinations of cash flow contingency terms and control rights used. Extant theoretical work explains such variation by arguing that each investor finely tailors contracts to mitigate investment‐specific incentive problems. We provide overwhelming evidence from 4,561 venture capital (VC) contracts that this tailoring is overstated: even though there is broad variation in contracting across VCs, each individual VC tends to specialize, recycling familiar terms. In fact, a VC typically restricts contracting choices to a small set of alternatives: 46% of the time, a VC uses the same exact cash flow contingencies as in one of her previous five contracts. We document specialization in both aggregated downside protection, and in each individual cash flow contingency term. Such specialization remains economically and statistically significant even after controlling for VC and company characteristics. We also find that VCs learn to use new contractual solutions from other VCs in her syndication network. Our findings challenge the traditional premise that each investor selects from the universe of combinations of terms to match an investment's unique contracting problem. Rather, the cumulative evidence indicates that contract‐specialization arises because investors better understand payoff consequences of familiar terms, and are reluctant to experiment with unknown combinations.     

Uniform and nonuniform staggering of wage contracts

This paper provides a model that can account for the almost uniform staggering of wage contracts in some countries as well as for the markedly nonuniform staggering in others. In the model, short and long contracts as well as long contracts concluded in different periods are strategic substitutes, which provide a powerful rationale for staggering. We show that for realistic parameter values, there is a continuum of possible equilibria with various degrees of staggering of long contracts. If the contracting cost is not too large, then the lowest possible degree of staggering decreases with the contracting cost and increases with monetary uncertainty.     

The challenge of using standard contracts in public–private partnerships

A call for an increased use of standard contracts in public–private partnerships (PPPs) for infrastructure development is noticeable in practice. These contracts are expected to simplify and improve procurement by creating opportunities for learning, lower transaction costs, and better competition. This paper delineates standard contracts in PPP as a new venue for research and unfolds their potential impact. Here lies an important challenge since the benefits of standardization are not as straightforward as they look at first sight, particularly when taking into account the tension between the powerful, control-oriented role of contracting authorities and the need for contingent, informal contracting.     

Long-term work contracts versus sequential spot markets: experimental evidence on firm-specific investment

The length of work contracts may be irrelevant for firm-specific investment if rational behavior generates endogenous job security. In an experiment, we implement such a situation and study actual investment behavior. In contrast to the game-theoretic prediction, we find reduced investment in case of short-term contracting compared to long-term contracting. This is due to nonequilibrium behavior that generates a substantial risk of unemployment if contracts are short-term. Since the effect of nonequilibrium behavior differs between institutions, the length of contract is in fact relevant for firm-specific investment.     

International Franchising Practices in Mexico: Do Franchisors Customize Their Contracts?

The contracting practices of franchisors outside their domestic market have received little attention in the empirical literature on franchising to date, largely because of lack of data. We exploit a novel data set that allows us to describe the contracts offered by a number of US and Canadian franchisors operating in Mexico and also compare them to contracts employed at home. Our analyses reveal a series of stylized facts that we hope will prove useful in guiding future empirical and theoretical research on contracting and especially on cross-border contracting practices. These are as follows: (1) The overwhelming majority of franchisors seeking franchisees in Mexico offer exactly the same contract to potential Mexican franchisees as that employed in the home market; (2) Among those franchisors that already have established outlets in Mexico, nearly half use the exact same fees in Mexico and at home; (3) The majority of those franchisors that make changes only alter the fixed fee component of the contract; (4) There is no evidence that franchisors use franchising more or less in Mexico compared to home as an alternative to royalty rate customization—in fact, the extent of franchising (versus company-owned units) of these firms in Mexico is not different systematically from that observed in their domestic market or worldwide; and (5) There is no evidence of increased customization over time—if anything, the evidence suggests increased similarities in contracting practices over time.     

DELEGATED PORTFOLIO MANAGEMENT: A SURVEY OF THE THEORETICAL LITERATURE

Abstract.  This paper provides a selective review of the theoretical literature on delegated portfolio management as a principal–agent relationship. The main focus of the paper is to review the analytical issues raised by the peculiar nature of the delegated portfolio management relationship within the broader class of principal–agent models. In particular, the paper discusses the performance of linear versus nonlinear compensation contracts in a single-period setting, the possible effects of limited liability of portfolio managers, the role of reputational concerns in a multiperiod framework, and the incentives to noise trading. In addition, the paper deals with some general equilibrium dimensions and asset pricing implications of delegated portfolio management. The paper also suggests some directions for future research.     

Public Contracts as Accountability Mechanisms: Assuring quality in public health care in England and Wales

Contracting in the public sector is designed to enhance the accountability of service providers to their funders. The idea is that quality is improved by the use of service specifications, monitoring of performance and imposition of contractual sanctions. Socio-legal and economic theories of contract indicate that it will be difficult to make and enforce contracts to achieve this. The results of a study of National Health Services contracting in England and Wales are reported. We conclude that contracts alone are not sufficient to improve accountability – collibration of various regulatory measures (including more hierarchical mechanisms such as performance targets) is required.     

Financial contracts as coordination device

We study the use of financial contracts as bid‐coordinating device in multi‐unit uniform price auctions. Coordination is required whenever firms face a volunteer's dilemma in pricing strategies: one firm (the “volunteer") is needed to increase the market clearing price. Volunteering, however, is costly, as inframarginal suppliers sell their entire capacity whereas the volunteer only sells residual demand. We identify conditions under which signing financial contracts solves this dilemma. We test our framework exploiting data on contract positions by large producers in the New York power market. Using a Monte Carlo simulation, we show that the contracting strategy is payoff dominant and provide estimates of the benefits of such strategy.     

Selection into and across credit contracts: Theory and field research

Lenders may choose to encourage borrower side contracting using group, or co-signed, loans or discourage it using individual loans, so as to make relative performance comparisons. In this context wealth of the agents relative to outsiders, and wealth inequality among potential joint liability partners, are important factors determining the choice among loan contracts. In a related model of whether to borrow, higher covariance of returns mitigates an adverse selection effect. We test these models using relatively rich data gathered in field research in Thailand. The prevalence of joint liability contracts relative to individual contracts exhibits a U-shaped relationship with the wealth of the borrowing household and increases with the wealth dispersion. The likelihood of joint-liability borrowing increases the lower is the probability of project success, a direct affirmation of adverse selection. Higher correlation across projects makes joint liability borrowing more likely relative to all other alternatives. Strikingly, most of the results disappear if we do not condition the sample according to the dictates of the models, with selection into and across credit contracts.     

Sector choices for public service delivery The transaction cost implications of executive turnover

The question of whether private firms should contract out for products and services or provide them internally (i.e. become more vertically integrated) has been a topic that has concerned scholars for many years. This article argues that the transaction costs in local contracting choices are linked to the characteristics of political systems that influence political and administrative uncertainty. Our analysis examines the transaction costs that result from executive turnover. Specifically, we are concerned with how uncertainty resulting from turnover in leadership positions in city government affects the ability of a municipality to negotiate contracts, make credible commitments to suppliers and faithfully uphold and enforce contracts once they are in force. We find that manager turnover reduces the likelihood of contracting with private sector providers. Mayor turnover has the opposite effect increasing contracting with both government and for-profit providers.     

Auditor independence,incomplete contracts and the role of legal liability

We develop a model in which there is conflict of interest between the management and the shareholders of an organization. Incompleteness of contracts prevents a simple contracting solution to this problem. We suggest that auditors can play a role in aligning the conflicting interests. However, this result is dependent on auditors maintaining independence from management. Again however, incompletenesses in contracting causes difficulties because it may be hard to ensure that auditors maintain this required independence. In this context, the imposition of potential legal liability (punishment) on the auditor, may be an important commitment mechanism for the auditors, making it credible that they will not collude with the management. In order to give our model institutional structure we study how this collusion may take place through the reappointment concerns of the auditor. In the reappointment game, we consider how legal liability levels could be chosen so that it becomes credible to expect that auditors will not implicitly collude with management and provide a low duty of care.     

Dynamic contracting under imperfect public information and asymmetric beliefs

We develop a dynamic principal–agent model to show how imperfect public information and asymmetric beliefs about payoff-relevant parameters, agency conflicts, and the agent's implicit incentives to influence the principal's posterior beliefs through his unobservable actions interact to affect optimal dynamic contracts. We make a methodological contribution to the literature by solving the continuous-time contracting problem using a discrete-time approximation approach. We obtain a simple characterization of optimal renegotiation-proof contracts in terms of the solution to a nonlinear ordinary differential equation (ODE). We then exploit the properties of the ODE to derive a number of novel implications for the dynamics of long-term contracts that alter the intuition gleaned from the previous literature. Optimism has a first-order impact on incentives, investment and output that could reconcile the “private equity” puzzle. Consistent with empirical evidence, the interaction between asymmetric beliefs, risk-sharing and adverse selection costs could cause the time-paths of the agent's incentive intensities to be increasing or decreasing. Our results also suggest that the incorporation of imperfect public information and asymmetric beliefs could potentially reconcile empirical evidence of an ambiguous relation between risk and incentives, and a non-monotonic relation between firm value and incentives. Permanent and transitory components of risk have differing effects on incentives, which suggest that empirical investigations of the link between risk and incentives should appropriately account for different components of risk.     

Reputation, Product Quality, and Warranties

This paper studies the firm's choice between implicit and explicit contracts as alternative methods of assuring product quality. The relationship between these two contractual forms is studied using a dynamic model with imperfect monitoring and team moral hazard where both the firm and the consumer take unobservable actions that affect product performance. The firm chooses the contractual arrangement that maximizes expected profit. Identified are conditions on the primitive attributes of the transactions and on the firm's environment that can help explain why firms might decide to use explicit contracting, implicit contracting, or a combination of the two. I also show that there are conditions under which the introduction of reputation causes explicit contracts to be more uniform and less sensitive to the details of the transaction than implied by static models.     

Independent and dependent contracting: Meaning and implications

In the context of the changing nature of work and the continuing growth of contingent employment contracts, this article examines the consequences associated with various forms of individually-negotiated, fixed-term contracts. This article first draws a distinction between what can be labeled as independent contracting arrangements, where the workers are autonomous and mobile, and other situations where contractors are more “dependent” on their clients. This investigation then provides an overview of the consequences associated with the employment of “independent” and “dependent” contractors. Based on a review of the existing research literature, the article examines the prescribed and realized benefits of individual contracting from the perspectives of the organization, the permanent employees, and the contractors themselves. Finally, the article concludes with some suggestions for human resource management (HRM) practice as well as areas in need of future research attention.     

Delegating optimal monetary policy inertia

In a forward-looking business cycle model, central banks can achieve the (timeless)optimal commitment equilibrium even in the absence of a commitment technology, if they are delegated with an objective function that is different from the societal one. The paper develops a general linear-quadratic method to solve for the optimal delegation parameters that generate the optimal amount of inertia in a Markov-perfect equilibrium, and studies the optimal design of some policy regimes that are nested within this framework: the (squared) optimal targeting rule; inflation, output-gap growth and nominal income growth targeting; and inflation and output-gap contracts.     

Contract Law and the Governance of Inter‐Firm Technology Partnerships – An Analysis of Different Modes of Partnering and Their Contractual Implications*

abstract This paper studies some major legal implications of inter‐firm technology partnering through equity joint ventures, non‐equity partnerships, and licensing contracts. These different partnerships are placed within the classical and relational contracting perspectives, while also considering intellectual property rights issues. Samples of contracts of partnerships in bioscience, fine chemicals, biotechnology and biopharmaceuticals are analysed, in detail, with reference to the distribution of property rights, major contractual clauses, and measures for conflict resolution. Equity joint ventures and non‐equity partnerships are found to largely follow a relational contracting perspective, while licensing contracts are governed by a classical contracting perspective.