A theory of delegated search for the best alternative

Searching for the best worker, a reliable supply alternative, or the most profitable investment is frequently delegated to an agent. This article develops a theory of delegated search. We show that the principal’s ability to delegate depends on the agent’s luck, her initial resources, and the contract that governs her search. With moral hazard, the optimal contract is characterized by performance deadlines with bonuses for early completion. If performance cannot be specified, the optimal search is implemented by an option‐to‐buy contract for the principal. If performance is partially specified, the optimal contract is a standard pay‐for‐performance arrangement.     

Costly contracting in a long‐term relationship

We examine a model of contracting where parties interact repeatedly and can contract at any point in time, but writing formal contracts is costly. A contract can describe the external environment and the parties' behavior in a more or less detailed way, and the cost of writing a contract is proportional to the amount of detail. We consider both formal (externally enforced) and informal (self‐enforcing) contracts. The presence of writing costs has important implications both for the optimal structure of formal contracts, particularly the tradeoff between contingent and spot contracting, and for the interaction between formal and informal contracting. Our model sheds light on these implications and generates a rich set of predictions about the determinants of the optimal mode of contracting.     

Contracting with private knowledge of signal quality

We characterize the optimal procurement contract in a setting where a supplier has privileged knowledge of the quality of a public signal about his production costs. The optimal contract exhibits important differences with standard contracts in adverse selection settings. For instance, the contract induces output both above and below first‐best levels. Furthermore, the induced output may not vary with the realized public signal unless the signal quality is sufficiently pronounced. In addition, output may increase as expected costs increase.     

Implementing high‐powered contracts to motivate intertemporal effort supply

We characterize the optimal contract between a principal and a risk‐neutral, wealth‐constrained agent when an adverse selection problem follows a moral hazard problem. The optimal contract in this setting often is more steeply sloped for the largest output levels than is the optimal contract in either the standard moral hazard setting or the standard adverse selection setting. The large incremental rewards for exceptional performance motivate the agent to deliver substantial effort both before and after he acquires privileged information about the production environment.     

Leading Indicator Variables, Performance Measurement, and Long-Term Versus Short-Term Contracts

In this article we develop a multiperiod agency model to study the role of leading indicator variables in managerial performance measures. In addition to the familiar moral hazard problem, the principal faces the task of motivating a manager to undertake “soft” investments. These investments are not directly contractible, but the principal can instead rely on leading indicator variables that provide a noisy forecast of the investment returns to be received in future periods. Our analysis relates the role of leading indicator variables to the duration of the manager's incentive contract. With short‐term contracts, leading indicator variables are essential in mitigating a holdup problem resulting from the fact that investments are sunk at the end of the first period. With long‐term contracts, leading indicator variables will be valuable if the manager's compensation schemes are not stationary over time. The leading indicator variables then become an instrument for matching the future investment return with the current investment expenditure. We identify conditions under which the optimal long‐term contract induces larger investments and less reliance on the leading indicator variables as compared with short‐term contracts. Under certain conditions, though, the principal does better with a sequence of one‐period contracts than with a long‐term contract.     

Contracting in the shadow of the law

Economic models of contract typically assume that courts enforce obligations based on verifiable events (corresponding to the legal rule of specific performance). As a matter of law, this is not the case. This leaves open the question of optimal contract design given the available remedies used by the courts. This article shows that American standard form construction contracts can be viewed as an efficient mechanism for implementing building projects given existing legal rules. It is shown that a central feature of these contracts is the inclusion of governance covenants that shape the scope of authority and regulate the ex post bargaining power of parties. Our model also implies that the legal remedies of mistake, impossibility and the doctrine limiting damages for unforeseen events developed in the case of Hadley v. Baxendale are efficient solutions to the problem of implementing complex exchange.     

Information control in the hold‐up problem

We study the use of information control to mitigate hold‐up risks. We identify a distinction between asymmetric information that creates an ex ante investment incentive and asymmetric information that causes ex post inefficiency, which then allows ex post inefficiency to be eliminated without compromising the ex ante investment incentive. We characterize the properties of the optimal information structure and the payoffs and welfare achievable with information control in the presence of hold‐up risks.     

Insurance Contract Design When the Insurer Has Private Information on Loss Size

This article examines the optimal indemnity contract in an insurance market, when the insurer has private information about the size of an insurable loss. Both parties know whether or not a loss occurred, but only the insurer knows the true value of the loss and/or to what extent the losses are covered under the policy. The insured may verify the insurer's loss estimate for a fixed auditing cost. The optimal contract reimburses the auditing costs in addition to full insurance for losses less than some endogenous limit. For losses exceeding this limit, the contract pays a fixed indemnity and requires no monitoring. The optimal contract is compared with the contracts obtained in cases where it is only the insured who can observe the loss size.
     

The price of advice

We develop a model of consulting (advising) where the role of the consultant is to reveal signals to her client that refine the client's original private estimate of the profitability of a project. Although the client can perfectly observe and evaluate these signals, the consultant may only be able to do the same imperfectly, or not at all. This captures the idea that the expert may not fully understand the impact of her advice on the client. We characterize the optimal contract between the consultant and her client. It is a menu consisting of pairs of transfers specifying payments between the two parties in case the project is undertaken by the client and in case it is not. The main result of the article is that in the optimal mechanism, the consultant obtains the same profit as though she could perfectly observe and evaluate the impact of the signals whose release she controls on the client's profit estimate.     

Optimal state‐contingent regulation under limited liability

We consider an optimal regulation model in which the regulated firm's production cost is subject to random, publicly observable shocks. The distribution of these shocks is correlated with the firm's cost type, which is private information. The regulator designs an incentive‐compatible regulatory scheme, which adjusts itself automatically ex post given the realization of the cost shock. We derive the optimal scheme, assuming that there is an upper bound on the financial losses that the firm can sustain in any given state. We first consider a two‐type, two‐state case, and then extend the results to the case of a continuum of firm types and an arbitrary finite number of states. We show that the first‐best allocation can be implemented if the state of nature conveys enough information about the firm's type and/or the maximal loss that the firm can sustain is sufficiently large. Otherwise, the solution is characterized by classical second‐best features.     

Unobserved investment,endogenous quality,and trade

A seller can make investments that affect a tradable asset’s future returns. The potential buyer of the asset cannot observe the seller’s investment prior to trade, nor does he receive any signal of it, nor can he verify it in any way after trade. Despite this severe moral‐hazard problem, this article shows the seller will invest with positive probability in equilibrium and that trade will occur with positive probability. The outcome of the game is sensitive to the distribution of bargaining power between the parties, with a holdup problem existing if the buyer has the bargaining power. A consequence of the holdup problem is surplus‐reducing distortions in investment level. Perhaps counterintuitively, in many situations, this distortion involves an increase in the expected amount invested vis‐à‐vis the situation without holdup.     

Cooperative investments induced by contract law

I revisit 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, I argue that this negative result follows from their implicit assumption of unilateral expectation damages. Yet the very nature of cooperative investments gives rise to the possibility that both parties may claim expectation damages. I show 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.     

Liquidity Premia and Transaction Costs

Standard literature concludes that transaction costs only have a second‐order effect on liquidity premia. We show that this conclusion depends crucially on the assumption of a constant investment opportunity set. In a regime‐switching model in which the investment opportunity set varies over time, we explicitly characterize the optimal consumption and investment strategy. In contrast to the standard literature, we find that transaction costs can have a first‐order effect on liquidity premia. However, with reasonably calibrated parameters, the presence of transaction costs still cannot fully explain the equity premium puzzle.     

Efficiency out of disorder: Contested ownership in incomplete contracts

In many situations, irreconcilable disagreements between players lead to costly ownership disputes over assets—for example, in case of joint ownership. This article studies the role of such disputes in a situation where two players have to make a transaction‐specific investment and when contracts are incomplete. I show that potentially contested ownership may mitigate the inefficiency of investments due to the incompleteness of contracts generating an exchange surplus that comes closer to the first‐best surplus as compared to any other ex ante distribution of ownership typically discussed in the literature following the influential work by Grossman, Hart, and Moore. If the contest is an all‐pay auction, each player makes a transaction‐specific investment as if he or she owns the asset. This article can explain why shared ownership—as for example in equity joint ventures, family firms, start‐up partnerships, and so on—is an important part of today's corporate landscape.     

Two Modes of Investment Banking: Technocrats,Relationship Managers,and Conflict

Efficient capital allocation in a market economy depends on the exchange of reliable information between providers of capital and companies that seek to put capital to work. One challenge, however, is that information exchange is at most only partly subject to verification and contractual arrangements. Take the case of securities issuance, including IPOs; whereas issuers of the new securities have incentives to overstate their prospects to attract higher bids, prospective investors have incentives to understate their interest. In principle, the counterparties could enter into an agreement that would prevent or discourage misrepresentations by both sides, but failure to perform would be very costly, if not impossible, for a court to verify. Investment banks have traditionally addressed this problem by creating extralegal markets for information whose functioning depends on the reputations of the banks for upholding the interests of both their corporate clients and the providers of capital. But committing to strike the right balance among all of the parties’ interests means that relational investment bankers inevitably face conflicts of interest. The authors of this article argue that such bankers exist to absorb and to manage conflicts of interest in financial markets—and that they do so by exercising judgment in ways that support their reputation for fair dealing. Modern full‐service investment banks, when addressing such conflicts, combine, or braid, such relational functions with technocratic banking activities involving the use of technical skills with advanced information technology. In so doing, however, technocratic bankers substitute formal contracts for the informal judgment exercised by relational bankers; and as a result, they are less dependent on their banks’ reputations for fair dealing. Moreover, technocratic bankers often have powerful incentives to pursue a personal reputation by executing complex transactions that demonstrate their skill, even at the expense of their clients and the bank's reputation for fair dealing. Well‐governed braided banks can benefit from complementarities between relational and technocratic skills. Nevertheless, full‐service banks continue to struggle with governance problems. The authors discuss several market responses to these struggles, such as the growing use of boutique banks offering “unconflicted” sell‐side advice in mergers and acquisitions and securities offerings. But the authors view such responses as at most a first step toward achieving a new understanding of the extent of the challenge facing today's investment banks in carrying out their economic function of bringing together and balancing the interests of companies and their investors.     

Project selection and execution in teams

We use a mechanism‐design approach to study a team whose members select a joint project and exert individual efforts to execute it. Members have private information about the qualities of alternative projects. Information sharing is obstructed by a trade‐off between adaptation and motivation. We determine the conditions under which first‐best project and effort choices are implementable and show that these conditions can become relaxed as the team grows in size. We also characterize the second‐best mechanism and find that it may include a “motivational bias,” that is, a bias in favor of the team's initially preferred project, and higher‐than‐optimal effort by uninformed team members.     

Corporate fraud and investment distortions in efficient capital markets

Inefficient investment allocation induced by corporate fraud, where informed insiders strategically manipulate outside investors' beliefs, has been endemic historically and has recently attracted much attention. We reconcile corporate fraud and investment distortions with efficient capital markets, building on shareholder‐manager agency conflicts and investment renegotiation in active takeover markets. Because investments that are ex post inefficient are not renegotiation proof, the optimal renegotiation‐proof contract induces overstatements by managers, accompanied by overinvestment in low return states and underinvestment in high return states by rational investors. Our framework also helps explain why easy access to external capital appears to facilitate corporate fraud.     

Efficient tournaments within teams

We analyze incentive problems in team and partnership structures where the only available information to condition a contract on is a partial and noisy ranking which specifies who comes first in efforts among the competing partners. This enables us to ensure both first‐best efficient effort levels for all partners and the redistribution of output only among partners. Our efficiency result is obtained for a wide range of cost and production functions.     

Optimal Reciprocal Reinsurance Treaties Under the Joint Survival Probability and the Joint Profitable Probability

A reinsurance treaty involves two parties, an insurer and a reinsurer. The two parties have conflicting interests. Most existing optimal reinsurance treaties only consider the interest of one party. In this article, we consider the interests of both insurers and reinsurers and study the joint survival and profitable probabilities of insurers and reinsurers. We design the optimal reinsurance contracts that maximize the joint survival probability and the joint profitable probability. We first establish sufficient and necessary conditions for the existence of the optimal reinsurance retentions for the quota‐share reinsurance and the stop‐loss reinsurance under expected value reinsurance premium principle. We then derive sufficient conditions for the existence of the optimal reinsurance treaties in a wide class of reinsurance policies and under a general reinsurance premium principle. These conditions enable one to design optimal reinsurance contracts in different forms and under different premium principles. As applications, we design an optimal reinsurance contract in the form of a quota‐share reinsurance under the variance principle and an optimal reinsurance treaty in the form of a limited stop‐loss reinsurance under the expected value principle.     

Strategic ex ante contracts: rent extraction and opportunity costs

This article cosiders the possibility that a seller can contract with one uninformed buyer prior to an auction involving two potential buyers. The seller's optimal strategic ex ante contract more accurately reflects joint opportunity costs of the seller and the contracted buyer, and therefore extracts more rent from the entrant. Moreover, this ex ante contract mitigates the seller's ex post rent seeking vis‐à‐vis the contracted buyer. Accordingly, it may create more social welfare than the absence of ex ante contracts, depending upon the contracted buyer's financial constraint and the distributions of trade surplus. Implementation of the optimal strategic ex ante contract and policy implications are discussed.