Efficient Contracting and Fair Play in a Simple Principal-Agent Experiment

We study behavior within a simple principal-agent experiment. Our design allows for a large class of linear contracts. Principals can offer any feasible combination of (negative) fixed wages and incentives in the form of return sharing. This great contractual flexibility allows us to study incentive compatibility simultaneously with issues of 'fair sharing' and reciprocity, which were previously found to be important. We find a high degree of incentive-compatible behavior, but also 'fair sharing' and reciprocity. In contrast to other incentive devices studied in the literature, the incentives are 'reciprocity-compatible'. Principals recognize the agency problem and react accordingly.     

Incentives for input foreclosure

We analyze the incentives of a vertically integrated firm to foreclose downstream rivals in a model of upstream price competition between suppliers of only imperfectly substitutable inputs. Our main motivation is a critical assessment of common assertions that draw inferences from pre-merger observable variables to post-merger incentives to foreclose. In particular, we find that, contrary to some commonly expressed views, high margins on the downstream and low margins on the upstream market are not good predictors for the incentives of a newly integrated firm to foreclose rivals. Besides this contribution to policy, our model also extends existing results in the literature on vertical foreclosure through allowing for the interaction of product differentiation on the upstream and on the downstream market.     

Carbon leakage revisited: unilateral climate policy with directed technical change

Using a stylized theoretical model, we argue that current economic analyses of climate policy tend to over-estimate the degree of carbon leakage, as they abstract from the effects of induced technological change. We analyse carbon leakage in a two-country model with directed technical change, where only one of the countries enforces an exogenous cap on emissions. Climate policy induces changes in relative prices, that cause carbon leakage through a terms-of-trade effect. However, these changes in relative prices also affect the incentives to innovate in different sectors. This leads to a counterbalancing induced-technology effect, which always reduces carbon leakage. We therefore conclude that the leakage rates reported in the literature may be too high, as these estimates neglect the effect of price changes on the incentives to innovate.      

TRACING THE EFFECTS OF GUARANTEED ADMISSION THROUGH THE COLLEGE PROCESS: EVIDENCE FROM A POLICY DISCONTINUITY IN THE TEXAS 10% PLAN

The Texas 10% law states that students who graduated among the top 10% of their high school class are guaranteed admission to public universities in Texas. We estimate the causal effects of this admissions guarantee on a sequence of connected decisions: students' application behavior, admission decisions by the university, students' enrollment choices conditional on admission; as well as the resulting college achievement. We identify these effects by comparing students just above and just below the top 10% rank cut off. We assume that other student characteristics and incentives are continuous at this cut off. We find that students react to incentives created by the admissions guarantee—for example, by reducing applications to competing private universities. The effects of the admissions guarantee depend on the university and the type of students it attracts. The 10% law is binding and alters the decisions of the admissions committees. We find little evidence that the law increases diversity or leads to meaningful mismatch for the marginal student admitted. (JEL I23, I28)     

Remain silent and ye shall suffer: seller exploitation of reticent buyers in an experimental reputation system

By providing incentives for sellers to act in a trustworthy manner, reputation mechanisms can mitigate moral-hazard problems when particular buyers and sellers interact infrequently. However, these mechanisms rely on buyers sharing their private information about sellers, and thus may suffer from too little feedback when provision is costly. We experimentally compare a standard feedback mechanism to one in which sellers can inspect a buyer’s feedback-provision history, thus providing incentives to share private information even when costly. We find fairly high trust and trustworthiness in all markets, with buyers providing costly feedback, especially negative, sufficient to induce trustworthiness. However, feedback-provision histories did not improve outcomes, and at least weakly decreased trustworthiness with experienced participants, as this information enabled sellers to discriminate and ship less frequently to buyers lacking a reputation for information sharing.     

Executive compensation: a calibration approach

Summary. We use a version of the Grossman and Hart principal-agent model with 10 actions and 10 states to produce quantitative predictions for executive compensation. Performance incentives derived from the model are compared with the performance incentives of 350 firms chosen from a survey by Michael Jensen and Kevin Murphy. The results suggest both that the model does a reasonable job of explaining the data and that actual incentives are close to the optimal incentives predicted by theory. Received: August 12, 1997; revised version: October 27, 1997     

Wealth Effects, Distribution, and the Theory of Organization

We construct a general equilibrium model of firm formation in which organization is endogenous. Firms are coalitions of agents providing effort and investment capital. Effort is unobservable unless a fixed monitoring cost is paid, and borrowing is subject to a costly state verification problem. Because incentives vary with an agent's wealth, different types of agents become attractive firm members under different circumstances. When borrowing is not costly, firms essentially consist of one type of agent and are organized efficiently. But when the costly state verification problem is sufficiently severe, firm organization will depend on the distribution of wealth: with enough inequality, it will tend to be dictated by incentives of rich agents to earn high returns to wealth, even if the chosen organizational form is not a technically efficient way to provide incentives.Journal of Economic LiteratureClassification Numbers: D2, D31, J41, L2.     

Merger Profitability and Trade Policy

We study the profitability incentives for merger and the endogenous industry structure in a strategic trade policy environment. Merger changes the strategic trade policy equlilibrium. We show that merger can be profitable and welfare enhancing, even though it would not be profitable in a laissez‐faire economy. A key element is a change in the governments’ incentives to give subsidies to their local firms. National merger induces more strategic trade policy, whereas international merger does not.     

Self-selection and the power of incentive schemes: an experimental study

We examine how self-selection of workers depends on the power of incentive schemes and how it affects team performance if the power of the incentive schemes is increased. In a laboratory experiment, we let subjects choose between (low-powered) team incentives and (high-powered) individual incentives. We observe that subjects exhibiting high trust or reciprocity in the trust game are more likely to choose team incentives. When exposed to individual incentives, subjects who chose team incentives perform worse if both the unobservable interdependency between their efforts and their incentive to cooperate under team incentives are high.     

Why Do Women Wait? Matching, Wage Inequality, and the Incentives for Fertility Delay

This paper explores the interaction between wage inequality and the marriage and fertility decisions of young women. We develop an equilibrium search model of marriage, divorce, and investment in children that allows for differential timing of fertility. We show how patterns of fertility timing in U.S. data can be explained by the incentives for fertility delay implied by marriage and labor markets. We find that these incentives help explain both the cross-sectional relationship between women's wages and fertility timing and the changes over the past 40 years in married women's fertility timing and labor supply. Journal of Economic Literature Classification Numbers: J12, J13.     

Profit sharing in unique Nash equilibrium: Characterization in the two-agent case

Two agents jointly operate a decreasing marginal returns technology to produce a private good. We characterize the class of output-sharing rules for which the labor-supply game has a unique Nash equilibrium. It consists of two families: rules of the serial type which protect a small user from the negative externality imposed by a large user, and rules of the reverse serial type, where one agent effectively employs the other agent's labor. Exactly two rules satisfy symmetry; a result in sharp contrast with Moulin and Shenker's characterization of their serial mechanism as the unique cost-sharing rule satisfying the same incentives property [Moulin, H., Shenker, S., 1992. Serial cost sharing. Econometrica 60 (5), 1009–1037]. We also show that the familiar stand-alone test characterizes the class of fixed-path methods under our incentives criterion [Friedman, E.J., 2004. Strong monotonicity in surplus sharing. Econ. Theory 23, 643–658].     

Bidding for brains: Intellectual property rights and the international migration of knowledge workers

We introduce international mobility of knowledge workers into a model of Nash equilibrium IPR policy choice among countries. We show that governments have incentives to use IPRs in a bidding war for global talent, resulting in Nash equilibrium IPRs that can be too high, rather than too low, from a global welfare perspective. These incentives become stronger as developing countries grow in size and wealth, thus allowing them to prevent the ‘poaching’ of their ‘brains’ by larger, wealthier markets.     

“Interest Rate Trap”, or Why Does the Central Bank Keep the Policy Rate Too Low for Too Long?

In this paper, we provide a framework for modeling one risk‐taking channel of monetary policy, the mechanism whereby financial intermediaries' incentives for liquidity transformation are affected by the central bank's reaction to a financial crisis. The anticipation of the central bank's reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering an “interest rate trap” – the economy will remain stuck in a long‐lasting period of suboptimal, low interest rate equilibrium. We demonstrate that interest rate policy as a financial stabilizer is dynamically inconsistent, and the constrained efficient outcome can be implemented by imposing ex ante liquidity requirements.     

Human Capital and Optimal Policy in a Lucas-Type Model

We present a design of fiscal policy capable of providing the required incentives to make a decentralized economy with externalities move along the optimal transitional path in a Lucas-type human capital model. Journal of Economic Literature Classification Numbers: O41, E62, J24.     

“(MA)LINGERING ON THE DISABLED LIST”

In this article, we examine two offsetting incentives that may affect a baseball player's willingness to play with injuries. We allow for the usual disincentive effects associated with long‐term contracts, while also incorporating the importance of the incentives associated with contract renewal. Our results are consistent with the previous work that showed those likely to retire at the end of their current contracts have an increased incentive to shirk. For those who expect to re‐sign a subsequent contract, however, we find that players tend to step up their effort as they approach the final year of their contract. (JEL L83)     

Non-commitment in performance evaluation and the problem of information distortions

Auditing is modeled in a sequential game without commitment. The manager must decide whether and where to audit a worker's output, taking into account all interim information he has obtained. The worker will work just hard enough (and show it) to divert the manager from making an audit or cover up, withholding information about his work to make an audit more difficult. This usually raises the costs of setting work incentives, so incentives are softened, sometimes drastically. Moreover, when a worker's on-the-job information is valuable for entrepreneurial decisions, work incentives must be softened to improve the internal flow of information.     

MARKET‐BASED INCENTIVES

In this article, we study market‐induced, external incentives similar to career concerns jointly with standard, contractual incentives linking compensation to performance. We consider a dynamic principal–agent problem in which the agent's outside option is determined endogenously in a competitive labor market. In equilibrium, strong performance increases the agent's market value. When this value becomes sufficiently high, the threat of the agent quitting forces the principal to increase the agent's compensation. The prospect of obtaining this raise gives the agent an incentive to exert effort, which reduces the need for standard incentives. In fact, whenever the agent's option to quit is sufficiently close to being “in the money,” the market‐induced incentive eliminates the need for standard incentives altogether: Compensation becomes completely insensitive to current performance.     

Observability and overcoming coordination failure in organizations: An experimental study

Motivated by problems of coordination failure in organizations, we examine how overcoming coordination failure and maintaining coordination depend on the ability of individuals to observe others’ choices. Subjects’ payoffs depend on coordinating at high effort levels in a weak-link game. Treatments vary along two dimensions. First, subjects either start with low financial incentives for coordination, which typically leads to coordination failure, and then are switched to higher incentives or start with high incentives, which usually yield effective coordination, and are switched to low incentives. Second, as the key treatment variable, subjects either observe the effort levels chosen by all individuals in their experimental group (full feedback) or observe only the minimum effort (limited feedback). We find three primary results: (1) When starting from coordination failure the use of full feedback improves subjects’ ability to overcome coordination failure, (2) When starting with good coordination the use of full feedback has no effect on subjects’ ability to avoid slipping into coordination failure, and (3) History-dependence, defined as dependence of current effort levels on past incentives, is strengthened by the use of full feedback. Electronic Supplementary Material Supplementary material is available in the online version of this article at . JEL Classification C92, D23, J31, L23, M52     

Risk adjustment and prevention

Abstract Widespread integration of market‐based incentives into healthcare systems calls for – and has elicited – increasing adoption of risk adjustment. By deterring selection, risk adjustment helps to assure fair and efficient payments among health insurers or capitated provider groups. However, since conventional risk adjustment allocates funds among regions or insurers according to current population health status, it does not reward – indeed, it penalizes – preventive efforts that improve population health. This prevention penalty of risk adjustment represents a hidden cost of unclear magnitude, undermining provider incentives for health promotion. We develop a theoretical model of selection and prevention demonstrating this problem with conventional risk adjustment and suggesting a simple alternative: risk adjustment should be linked to pay‐for‐performance for prevention.     

DETERMINANTS AND EFFECTS ON PROPERTY VALUES OF PARTICIPATION IN VOLUNTARY CLEANUP PROGRAMS: THE CASE OF COLORADO

State voluntary cleanup programs (VCPs) were established in the 1990s to encourage cleanup and redevelopment of contaminated properties. I ask three questions: First, what properties are attracted to VCPs? Second, is there an interaction between VCP incentives and enterprise or brownfield zone incentives? Third, does participation in VCPs affect property values? Data from Colorado’s VCP suggest that (a) the main determinants of participation are the size of the parcel and the surrounding land use, (b) other incentives have little effect, (c) properties with confirmed contamination sell at a 43%–56% discount, and (d) participation does tend to raise the property price. (JEL R14, Q58, K32)