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.     

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.     

Trade Credit and Informational Asymmetry

Commonly used trade credit terms implicitly define a high interest rate that operates as an efficient screening device where information about buyer default risk is asymmetrically held. By offering trade credit, a seller can identify prospective defaults more quickly than if financial institutions were the sole providers of short-term financing. The information is valuable in cases where the seller has made nonsalvageable investments in buyers since it enables the seller to take actions to protect such investments.     

Auctions versus negotiations: the effects of inefficient renegotiation

For the procurement of complex goods, the early exchange of information is important to avoid costly renegotiation. If the buyer can specify the main characteristics of possible design improvements in a complete contingent contract, scoring auctions implement the efficient allocation. If this is not feasible, the buyer must choose between a price‐only auction (discouraging early information exchange) and bilateral negotiations with a preselected seller (reducing competition). Bilateral negotiations are superior if potential design improvements are important, if renegotiation is very costly, and if the buyer's bargaining position is strong. Moreover, negotiations provide stronger incentives for sellers to investigate design improvements.     

Best foot forward or best for last in a sequential auction?

Should a seller with private information sell the best or worst goods first? Considering the sequential auction of two stochastically equivalent goods, we find that the seller has an incentive to impress buyers by selling the better good first because the seller's sequencing strategy endogenously generates correlation in the values of the goods across periods. When this impression effect is strong enough, selling the better good first is the unique pure‐strategy equilibrium. By credibly revealing to all buyers the seller's ranking of the goods, an equilibrium strategy of sequencing the goods reduces buyer information rents and increases expected revenues in accordance with the linkage principle.     

Robust pricing with refunds

Before purchase, a buyer of an experience good learns about the product's fit using various information sources, including some of which the seller may be unaware of. The buyer, however, can conclusively learn the fit only after purchasing and trying out the product. We show that the seller can use a simple mechanism to take best advantage of the buyer's post-purchase learning to maximize his guaranteed-profit. We show that this mechanism combines a generous refund, which performs well when the buyer is relatively informed, with non-refundable random discounts, which work well when the buyer is relatively uninformed.     

Transaction duration and asymmetric price impact of trades—Evidence from Australia

This paper investigates the asymmetric price impact of buyer and seller initiated trades and the informational role of the trade duration. Using trade data from the Australian Stock Exchange (ASX), our results indicate that buyer initiated trades increase the ask price more than the bid price, and seller initiated trades decrease the bid price more than the ask price. The transaction duration is modeled in a Box-Cox ACD framework. The unexpected portion of the duration is found to play a more significant role in causing price impact in both purchases and sales than the expected duration. A trade shortly after the previous trade results in higher price impact than one after a long period. We found evidence that increased trading activity is associated with larger price impact, therefore implying a higher degree of information-based trading.     

Payoff uncertainty,bargaining power,and the strategic sequencing of bilateral negotiations

This article investigates the sequencing choice of a buyer who negotiates with the sellers of two complementary objects with uncertain payoffs. The possibility of inefficient trade may generate strict sequencing preference. The buyer begins with the weaker seller if the sellers have diverse bargaining powers and with the stronger one if both sellers are strong bargainers. This sequencing is likely to increase the social surplus. Moreover, the buyer may find it optimal to raise her own acquisition cost by committing to a minimum purchase price or outsourcing. The first‐ and second‐mover advantages for the sellers are also identified.     

Effects of Competition on Insurance Contract Formation

For an insurance transaction between a single risk-averse buyer and single risk-neutral seller with positive transaction costs, it is well known that the buyer will prefer a policy contract with an ordinary deductible. More detailed results demonstrate the Pareto optimality of an insurance contract characterized by a deductible (followed by coinsurance) for a single risk-averse buyer and single risk-averse seller. In the present work, we employ a market-game model to solve for the equilibrium insurance contract. This formulation, which approximates the behavior of excess property insurance and property catastrophe reinsurance markets, reveals that the equilibrium policy is described by full insurance up to a given policy limit, with no deductible or coinsurance. Our analysis shows further that this solution persists regardless of the numbers of buyers and sellers in the market, and in particular that the market-game equilibrium does not converge to a Pareto-optimal result because of boundary constraints on the number of sellers. Finally, we test our price-formation mechanism against an important generalization, and find that the policy-limit contract persists.     

Methods of Payment in Asset Sales: Contracting with Equity versus Cash

We analyze intercorporate asset sales where equity is the means of payment, and compare the results to cash asset sales. Equity deals are value‐enhancing for both buyers, 10%, and sellers, 3%, while cash sales generate seller returns of 1.9% and buyer returns that are not significant. Combined wealth gains are large for equity deals, but modest for cash deals. Equity‐based asset sales are not a precursor to consolidations between buyers and sellers, and do not affect buyer openness to the takeover market. We conclude that the use of buyer equity conveys favorable information about the value of assets and buyers.     

The accuracy of the tick test: Evidence from the Australian stock exchange

In the absence of information regarding whether a trade is buyer or seller initiated, many researchers have employed the ‘tick’ rule as a proxy. These researchers have been supported in their endeavours by the work of Lee and Ready (1991) which suggests that the tick rule is 90% accurate. Unfortunately, the difficulty of securing data on this issue has made Lee and Ready's paper somewhat unique in that there have been few attempts to confirm their result in US markets and no attempts in other markets. The purpose of this work is to test the robustness of their result in the Australian securities market. Using cleaner intra-day data we mimic the Lee and Ready study to cast some doubt upon the robustness of their findings in different markets. Our results suggest an overall accuracy of approximately 74% as opposed to Lee and Ready's 90%. However, accuracy in excess of 90% is documented when zero ticks are excluded. Further analysis provides evidence that a volatile or trending market will decrease the accuracy of the tick rule. It is also demonstrated that the tick rule is less likely to accurately classify seller initiated trades and small buyer initiated trades.     

Trade Credit Terms: Asymmetric Information and Price Discrimination Evidence From Three Continents

Abstract:   Trade credit terms offer firms contractual solutions to informational asymmetries between buyers and sellers. The credit period permits buyers to reduce uncertainty concerning product quality prior to payment, while the seller can reduce uncertainty concerning buyer payment intentions by prescribing payment before/on delivery or through two‐part payment terms and other mechanisms. Variation in trade credit terms also offers firms price discriminating opportunities. This study, drawing on the responses of 700 large firms in the US, UK and Australia, explores trade credit terms through the twin objectives of reducing information asymmetries and discriminatory pricing. Support is found for both theories.     

The anatomy of buyer–seller dynamics in decentralized markets

In this paper I investigate the nexus between buyer–seller dynamics, financial frictions and market efficiency in decentralized markets. To do so, I introduce financial frictions in a dynamic market with heterogeneous traders. Heterogeneously constrained buyers sequentially enter the market to acquire units of a generic good from heterogeneously endowed sellers. I characterize two closely related classes of equilibria, respectively called homogeneous equilibrium with no entry (HEWNE) and homogeneous equilibrium with entry (HEWE). Both equilibria prescribe a market where only the efficiently endowed type of seller exists in the limit. However, the two equilibria diverge in the specification of agents’ behavior subsequent to trade. In HEWNE, sellers and buyers exit the market upon successful trading. In HEWE, like in supply chains, in every period certain types of buyers replace exiting sellers, thus becoming potential sellers for subsequent waves of buyers. First, I identify the critical role of frictions in steering the complex evolution of market heterogeneity for both classes of equilibria. Secondly, I operationalize the combined study of HEWNE and HEWE to obtain sharp predictions on market efficiency for a range of empirically-relevant situations in which buyer–seller dynamics are decoupled, for example when entry of new sellers is delayed or stopped. Third, I test the theoretical findings against a simulated artificial market.     

An optimal auction with identity‐dependent externalities

We analyze the problem of a seller of multiple identical units of a good who faces a set of buyers with unit demands, private information, and identity‐dependent externalities. We derive the seller's optimal mechanism and characterize its main properties. We show that the probability that a buyer obtains a unit is an increasing function of the externalities he generates and enjoys. Also, the seller's allocation of the units of the good need not be ex post efficient. As an illustration, we apply the model to the problem faced by a developer of a shopping mall who wants to allocate and price its retail space among anchor and non‐anchor stores. We show that a commonly used sequential mechanism is not optimal unless externalities are large enough.     

How limiting deceptive practices harms consumers

There are two competing sellers of an experience good, one offers high quality, one low. The low‐quality seller can engage in deceptive advertising, potentially fooling a buyer into thinking the product is better than it is. Although deceptive advertising might seem to harm the buyer, we show that he could be better off when the low‐quality seller can engage in deceptive advertising than not. We characterize the optimal deterrence rule that a regulatory agency seeking to punish deceptive practices should adopt. We show that greater protection against deceptive practices does not necessarily improve the buyer welfare.     

Trade credit and credit rationing

Asymmetric information between banks and firms can precludefinancing of valuable projects. Trade credit can alleviate thisproblem by incorporating the lending relation the private informationheld by suppliers about their customers. Incentive compatibilityconditions prevent collusion between two of the agents (e.g.,the buyer and the seller) against the third (e.g., the bank).Consistent with the empirical findings of Petersen and Rajan(1995), firms without relationships with banks resort more totrade credit, and sellers with greater ability to generate cashflows provide more trade credit. Finally small firms react tomonetary contractions by using trade credit, consistent withthe empirical results of Nilsen (1994).     

The upstairs market for large-block transactions: analysis and measurement of price effects

This article develops a model of the upstairs market where ordersize, beliefs and prices are determined endogenously. We testthe model's predictions using unique data for 5,625 equity tradesduring the period 1985 to 1992 that are known to be upstairstransactions and are identified as either buyer or seller initiated.We find that price movements prior to the trade date are significantlypositively related to trade size, consistent with informationleakage as the block is 'shopped' upstairs. Further, the temporaryprice impact or liquidity effect is a concave function of ordersize, which may result from upstairs intermediation.     

Asset sales in the mutual fund industry: Who gains?

We analyze gains from intercorporate sales of mutual fund subsidiaries, using mandated SEC disclosures to assess the performance of mutual funds transferred by these transactions. Sellers are financial conglomerates (banks) using equity-based deals to transfer poorly performing funds to highly focused asset management companies. The transferred funds experience significant improvements in risk-adjusted returns, efficiency, and asset growth. These improvements are closely correlated with the gains in wealth to buyers and sellers at deal announcements, indicating the market efficiently capitalizes expected performance improvements. Our results provide evidence that these transactions transfer assets to acquirers better able to manage them, generating gains for fund holders and buyer and seller shareholders.     

Bargaining Strength and Property Class in Office Markets

This paper examines the influence of bargaining power and property class on the prices of heterogeneous goods. Specifically, it explores the impact of buyer and seller characteristics on the transaction prices of office properties. The empirical model is based on the work of Harding, Rosenthal, and Sirmans (2003), which developed a method to distinguish between the impact of buyer and seller attributes on bargaining power and the choice of otherwise unidentified price effects (i.e., property class) in the context of hedonic price models. The data set contains information on transaction prices of office properties in Cook, DuPage, and Lake Counties, Illinois from 1995 to 1997. The results reveal systematic differences in bargaining power and property class for certain groups of buyers and sellers contained within the sample.