Incentives and Standards in Agency Contracts

This paper studies the structure of state‐contingent contracts in the presence of moral hazard and multitasking. Necessary and sufficient conditions for the presence of multitasking to lead to fixed payments instead of incentive schemes are identified. It is shown that the primary determinant of whether multitasking leads to higher or lower powered incentives is the role that noncontractible outputs play in helping the agent deal with the production risk associated with the observable and contractible outputs. When the noncontractible outputs are risk substitutes and are socially undesirable, standards are never optimal. If the noncontractible outputs are socially desirable, standards are never optimal if the noncontractible outputs play a risk‐complementary role.     

The Economics of Clear Advice and Extreme Options

I study a principal–agent model in which the agent collects information and then chooses a verifiable action. I show that the principal can find it desirable to constrain the agent's action set even though there is no disagreement about the ranking of actions ex post . The elimination or penalization of „intermediate” actions, which are optimal when information is poor, improves incentives for information collection. I characterize optimal action sets when the agent is infinitely risk averse with respect to income shocks and optimal incentive schemes when the agent is risk neutral.     

Contracts payments for ecosystem services: the case of bio-pospecting

We examine the economics of royalties in bioprospecting contracts between a pharmaceutical and genetic resource supplier (local), with an eye to understanding the relative advantages of indexing royalty payments to gross revenue or net revenue. We show a risk-averse firm facing only production or only cost risks will index royalties to net revenue. When facing both types of risk, the choice of royalty type depends on the relative magnitudes of the production and cost risk. In each case, the risk-averse firm chooses the royalty type that shifts as much risk as possible to the local. When the local is risk neutral, the pharmaceutical's and local's preferences are compatible. If the local is risk averse and there is only one type of risk, it will prefer a gross revenue royalty, and shift as much risk as possible to the firm: here the local and firm preferences are compatible only if the firm is risk-neutral, Lastly, we show if the firm sets the terms of the contract, and both agents are risk averse, the firm will not likely volunteer to implement the socially optimal royalty arrangement as it prefers to shift as much risk to the local, who now also prefers a more certain return. This last outcome is at the heart of the benefit sharing discussion and suggests if risk sharing and equity are a concern in benefit sharing, then the choice of royalty type can be an important part of negotiations between pharmaceuticals and locals for the phytochemical from nature for new drug discovery.     

Rotating Savings and Credit Associations When Participants are Risk Averse*

We model rotating savings and credit associations (Roscas) among risk‐averse participants who experience privately observed income shocks. A random Rosca is not advantageous, whereas a bidding Rosca is if temporal risk aversion is less pronounced than static risk aversion. The payoff scheme of a bidding Rosca facilitates risk sharing in the presence of information asymmetries. The risk‐sharing performance of a simple arrangement where a group of homogenous individuals runs several bidding Roscas simultaneously is as good as that of a linear risk‐sharing contract, and is more enforceable because it carries a fixed rather than a variable contribution.     

Welfare Effects of Transparency in Foreign Exchange Markets: the Role of Hedging Opportunities

The paper studies the impact of more transparency on the risk‐sharing opportunities in the foreign exchange market and the associated implications on ex ante welfare. Transparency is measured in this model by the informational content of publicly observable signals about exchange rate developments. The authors find that in this model more transparency improves welfare in economies that are poorly endowed with capital and/or where investors are not very risk‐averse, while welfare is reduced in economies with large capital endowments and/or where investors are highly risk‐averse.     

Choosing the agent's group identity in a trust game with delegated decision making

Members of a given social group often favor members of their own group identity over people with different group identities. We construct a trust game in which the principal delegates the decision about an investment into a receiver to an agent who either favors the principal's or the receiver's group identity. When choosing the agent's group identity the principal faces a trade‐off between a loyal agent and an agent who might increase the receiver's willingness to cooperate. We solve for the principal's decision in a subgame‐perfect nash equilibrium for the two scenarios of a risk‐neutral and risk‐averse agent, respectively.     

Collusion, Delegation and Supervision with Soft Information

This paper shows that supervision with soft information is valuable whenever supervisors and supervisees collude under asymmetric information and proceeds then to derive an Equivalence Principle between organizational forms of supervisory and productive activities. We consider an organization with an agent privately informed on his productivity and a risk averse supervisor getting signals on the agent's type. In a centralized organization, the principal can communicate and contract with both the supervisor and the agent. However, these two agents can collude against the principal. In a decentralized organization, the principal only communicates and contracts with the supervisor who in turn sub-contracts with the agent. We show that the two organizations achieve the same outcome. We discuss this equivalence and provide various comparative statics results to assess the efficiency of supervisory structures.     

Optimal incentive contracts under inequity aversion

We analyze the classic moral hazard problem with the additional assumption that agents are inequity averse. The presence of inequity aversion alters the structure of optimal contracts. When the concern for equity becomes more important, there is convergence towards linear sharing rules. The sufficient statistics result is violated. Depending on the environment, contracts may be either overdetermined, i.e. include non-informative performance measures, or incomplete, i.e. neglect informative performance measures. Finally, our model delivers a simple rationale for team based incentives, implying wage compression.     

Speak softly, but carry a big stick: On optimal targets under moral hazard

When managerial compensation is restricted to be constant below a certain target output level, and underlying effort is unobserved, a recent article by Liu suggests that the optimal sharing rule should be smooth and locally convex at the target. This is incorrect. If minimum payments are set exogenously, the optimal sharing rule for a risk-averse manager will be kinked at the target. If penalties are unbounded, the principal can approach the first-best full-information outcome by offering a constant payment under normal conditions but imposing a severe punishment for extremely unlikely low outcomes, i.e., by “speaking softly but carrying a big stick.”     

Informational externalities,strategic delay,and optimal investment subsidies

Abstract This paper examines optimal government policy when private investment generates information, but investors cannot internalize the informational value their actions have to others. Equilibrium exhibits inefficient delay, as investors adopt a wait‐and‐see approach. The government can alter incentives via an investment subsidy, but complications arise, since future subsidies may induce investors to disregard current policy initiatives. The paper shows that the government achieves its desired outcome only when the the investment subsidy is financed by a non‐distortionary, lump‐sum tax. When taxation is distortionary, the government faces a time inconsistency problem that may prevent effective policy.     

Contract renegotiation and options in agency problems

This article discusses the ability of an agent and a principalto achieve the first-best outcome when the agent invests inan asset that has greater value if owned by the principal thanby the agent. When contracts can be renegotiated, a well-knowndanger is that the principal can hold up the agent, underminingthe agent's investment incentives. We begin by identifying acountervailing effect: Investment by the agent can increasehis value for the asset, thus improving his bargaining positionin renegotiation. We show that option contracts will achievethe first best whenever his threat-point effect dominates theholdup effect. Otherwise, achieving the first best is difficultand, in many cases, impossible.     

Performance, Promotion, and the Peter Principle

This paper considers why organizations use promotions, rather than just monetary bonuses, to motivate employees even though this may conflict with efficient assignment of employees to jobs. When performance is unverifiable, use of promotion reduces the incentive for managers to be affected by influence activities that would blunt the effectiveness of monetary bonuses. When employees are risk neutral, use of promotion for incentives need not distort assignments. When they are risk averse, it may—sufficient conditions for this are given. The distortion may be either to promote more employees than is efficient (the Peter Principle effect) or fewer.
" Promotions serve two roles in an organization. First, they help assign people to the roles where they can best contribute to the organization's performance. Second, promotions serve as incentives and rewards. " (Milgrom and Roberts (1992, p. 364))
" Promotions are used as the primary incentive device in most organizations, including corporations, partnerships, and universities . . . This . . . is puzzling to us because promotion-based incentive schemes have many disadvantages and few advantages relative to bonus-based incentive schemes. " (Baker, Jensen and Murphy (1988, p. 600))     

Contract Choice: Efficiency and Fairness in Revenue‐Sharing Contracts

We present a simple principal–agent experiment in which the principals are allowed to choose between a revenue‐sharing, a bonus, and a trust contract, to offer to an agent. Our findings suggest that a large majority of experimental subjects choose the revenue‐sharing contract. This choice turns out to be not only the most efficient but also, at the same time, fair. Overall, the distribution of earnings is only mildly skewed towards the principal. We conclude that, under revenue‐sharing contracts, concerns for fairness can be closely associated with the use of monetary incentives.     

Contracts with endogenous information

I study covert information acquisition and reporting in a principal agent problem allowing for general technologies of information acquisition. When posteriors satisfy two dimensional versions of the standard First Order Stochastic Dominance and Concavity/Convexity of the Distribution Function conditions, a first-order approach is justified. Under the same conditions, informativeness and riskiness of reports are equivalent. High powered contracts, that make the agent's informational rents more risky, are used to increase incentives for information acquisition, insensitive contracts are used to reduce incentives for information gathering. The value of information to the agent is always positive. The value of information to the principal is ambiguous.     

The effects of pay regulation when agents are loss averse

This article analyses the effects of a regulatory cap on executive pay when the agent is loss averse. I use a principal–agent model with moral hazard in which a principal and an agent bargain over an incentive contract. I show that even a non-binding cap on the agent’s payments can have consequences for the bargained outcome and consequently for the effort the agent exerts.     

MORAL HAZARD,RISK AVERSION AND EFFICIENCY

This note revisits the classic moral‐hazard model, but assumes that the output distribution has moving support and punishments are limited. The results show that the principal can implement an efficient solution if the agent is sufficiently risk averse.     

Disentangling managerial incentives from a dynamic perspective: The role of stock grants

We analyse the optimal contract between a risk‐averse manager and the initial shareholders in a two‐period model where the manager's investment effort, carried out in period 1, and his or her current effort, carried out in period 2, both impact the second‐period profit, so that it may be difficult to disentangle the incentives for these two types of effort. We show that stock grants play different roles according to whether the signal of investment effort is less noisy, or noisier, than that of current effort. We determine simultaneously the optimal stock grants and the optimal restrictions on sales of shares.     

Optimal sequential contract with a risk‐averse supplier

We study optimal contracts in environments where a risk‐averse supplier discovers cost information privately and gradually over time: the supplier is privately informed about its cost uncertainty at the time of contracting and discovers the realization of cost condition privately after contracting and before production. We show that both the buyer and the supplier prefer more cost uncertainty when the supplier is not very risk‐averse but less cost uncertainty when the supplier is sufficiently risk‐averse. However, the buyer always prefers to contract before the cost uncertainty resolves regardless of the supplier's degree of risk aversion. The nature of the optimal contract also depends on the supplier's risk preference. A separating contract is optimal when the supplier is not very risk‐averse; however, a pooling contract, which offers the same contract terms regardless of the cost uncertainty, can be optimal when the supplier becomes sufficiently risk‐averse. Moreover, the optimal production schedule is often characterized by “inflexible rules.”     

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.     

Modelling countervailing incentives in adverse selection models: A synthesis

This paper is concerned with countervailing incentives in the adverse selection problems that typically arise in principal-agent relationships when the agent has private information. These incentives are present when the agent is tempted to either overstate or understate his private information depending upon the specific realization of his type. These problems were first analyzed by Lewis and Sappington (1989) and have been characterized and extended by Maggi and Rodríguez-Clare (1995a) and Jullien (2000). In this paper we propose a simple method of characterizing countervailing incentives in which the key element is the analysis of the properties of the full information problem. Our method for solving the principal problem, once identified the presence of countervailing incentives, follows closely the Baron’s (1989) approach, which does not require using optimal control theory. The methodology we present can be easily applied to many different economic settings. For example, in health economics, an insurer (or a hospital manager) might act as a principal and a physician as an agent. In labor settings, an employer may play the role of principal and a worker may act as the agent. In regulated industries, the regulatory agency might act as a principal designing incentive schemes for firms (the agents). In environmental regulation or resource exploitation, the principal might be an international agency dealing with national governments or firms.