In this paper I examine a T-period agency model with imperfect public monitoring between a risk-neutral principal and a risk-averse agent where signals can depend on the agent's past actions and exhibit serial correlation. In this general environment, I show that near-efficiency obtains when T is large if the monitoring technology satisfies two basic properties: concentration of measure and informativeness. The tension between these properties determines the boundary at which asymptotic efficiency obtains in agency models with frequent actions, unifies and extends various efficiency results in the agency literature, quantifies the value of knowing detailed features of signal processes and solves a large class of incentive problems with highly persistent monitoring technologies.
{"title":"Efficiency in General Agency Models with Imperfect Public Monitoring","authors":"Anqi Li","doi":"10.2139/ssrn.2290373","DOIUrl":"https://doi.org/10.2139/ssrn.2290373","url":null,"abstract":"In this paper I examine a T-period agency model with imperfect public monitoring between a risk-neutral principal and a risk-averse agent where signals can depend on the agent's past actions and exhibit serial correlation. In this general environment, I show that near-efficiency obtains when T is large if the monitoring technology satisfies two basic properties: concentration of measure and informativeness. The tension between these properties determines the boundary at which asymptotic efficiency obtains in agency models with frequent actions, unifies and extends various efficiency results in the agency literature, quantifies the value of knowing detailed features of signal processes and solves a large class of incentive problems with highly persistent monitoring technologies.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"15 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-12-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"115275048","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We show how to improve payoffs such that any portfolio composed of contracts with the improved payoffs is more attractive than the corresponding portfolio with the original payoffs.Starting from an axiomatic characterisation, we derive an amelioration operator that yields payoffs attractive to both risk averse buyers and sellers of financial contracts, including individuals with robust Savage preferences. For comparison with our approach, we briefly recall and slightly generalise core results on expected utility optimisation and cost-efficient payoffs.Furthermore, we obtain a new variant of the axiomatic characterisation of pricing operators and show that ameliorated payoffs do not admit generalised statistical arbitrage.
{"title":"Utility-Efficient Payoffs","authors":"Stefan Kassberger, Thomas Liebmann","doi":"10.2139/ssrn.2515029","DOIUrl":"https://doi.org/10.2139/ssrn.2515029","url":null,"abstract":"We show how to improve payoffs such that any portfolio composed of contracts with the improved payoffs is more attractive than the corresponding portfolio with the original payoffs.Starting from an axiomatic characterisation, we derive an amelioration operator that yields payoffs attractive to both risk averse buyers and sellers of financial contracts, including individuals with robust Savage preferences. For comparison with our approach, we briefly recall and slightly generalise core results on expected utility optimisation and cost-efficient payoffs.Furthermore, we obtain a new variant of the axiomatic characterisation of pricing operators and show that ameliorated payoffs do not admit generalised statistical arbitrage.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"291 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-10-24","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"121446811","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Pub Date : 2014-08-27DOI: 10.4337/9781782547143.00020
T. Baker, Kyle D. Logue
The economic analysis of contract law can be organized around two general questions: (1) what are the efficient or welfare-maximizing substantive rules of contract law; and (2) once those rules have been identified, when if ever should they be made mandatory and when should they be merely “default rules” that the parties can contract around if they wish? Much of contract theory over the past twenty years has been devoted to developing answers to those two questions. The same two questions can be posed with respect to the rules of insurance law. Although previous scholars have examined particular substantive doctrines of insurance law (such as contra proferentem and the “duty to settle”), insurance law scholars as well as courts and legislatures have largely ignored whether and under what circumstances rules of insurance law generally should be mandatory. This article begins to fill that gap in the literature. The article articulates a straightforward efficiency-based approach to drawing the line between which rules in insurance law should be considered mandatory and which should be changeable by agreement of the parties. Specifically, the article suggests drawing the line in a way that is consistent with the market-failure rationale that justifies making contract rules mandatory in the first place. This same principle would apply to all contracts, not only insurance contracts. The article describes how insurance law currently draws the line between mandatory rules and default rules and evaluates whether those boundaries are consistent with the applicable market failure rationales. In addition, the article takes into account the unique role that state insurance regulators can play in helping courts decide which rules of insurance law, or terms in insurance contracts, are mandatory and which are defaults. Finally, the article explains how the rules/standards distinction must be considered in the design of the optimal mandatory/default-rule boundary.
{"title":"Mandatory Rules and Default Rules in Insurance Contracts","authors":"T. Baker, Kyle D. Logue","doi":"10.4337/9781782547143.00020","DOIUrl":"https://doi.org/10.4337/9781782547143.00020","url":null,"abstract":"The economic analysis of contract law can be organized around two general questions: (1) what are the efficient or welfare-maximizing substantive rules of contract law; and (2) once those rules have been identified, when if ever should they be made mandatory and when should they be merely “default rules” that the parties can contract around if they wish? Much of contract theory over the past twenty years has been devoted to developing answers to those two questions. The same two questions can be posed with respect to the rules of insurance law. Although previous scholars have examined particular substantive doctrines of insurance law (such as contra proferentem and the “duty to settle”), insurance law scholars as well as courts and legislatures have largely ignored whether and under what circumstances rules of insurance law generally should be mandatory. This article begins to fill that gap in the literature. The article articulates a straightforward efficiency-based approach to drawing the line between which rules in insurance law should be considered mandatory and which should be changeable by agreement of the parties. Specifically, the article suggests drawing the line in a way that is consistent with the market-failure rationale that justifies making contract rules mandatory in the first place. This same principle would apply to all contracts, not only insurance contracts. The article describes how insurance law currently draws the line between mandatory rules and default rules and evaluates whether those boundaries are consistent with the applicable market failure rationales. In addition, the article takes into account the unique role that state insurance regulators can play in helping courts decide which rules of insurance law, or terms in insurance contracts, are mandatory and which are defaults. Finally, the article explains how the rules/standards distinction must be considered in the design of the optimal mandatory/default-rule boundary.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"1 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-08-27","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"134269875","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Sumit Agarwal, Richard K. Green, E. Rosenblatt, Vincent Yao
Individuals and firms pledge collateral to mitigate agency costs or contracting frictions in a world with asymmetric information. However, the option value theory suggests that once the mark-to-market asset valuation is below the current debt, the firms and individuals should default on their debt contract irrespective of the initial collateral pledged. In this paper, we estimate default models and find that after controlling for mark-to-market asset valuation, initial collateral remains an important predictor of mortgage default. Specifically, individuals that pledge higher collateral have a lower hazard to default. Our results are consistent with models of sunk cost fallacy.
{"title":"Collateral Pledge, Sunk-Cost Fallacy and Mortgage Default","authors":"Sumit Agarwal, Richard K. Green, E. Rosenblatt, Vincent Yao","doi":"10.2139/ssrn.2446748","DOIUrl":"https://doi.org/10.2139/ssrn.2446748","url":null,"abstract":"Individuals and firms pledge collateral to mitigate agency costs or contracting frictions in a world with asymmetric information. However, the option value theory suggests that once the mark-to-market asset valuation is below the current debt, the firms and individuals should default on their debt contract irrespective of the initial collateral pledged. In this paper, we estimate default models and find that after controlling for mark-to-market asset valuation, initial collateral remains an important predictor of mortgage default. Specifically, individuals that pledge higher collateral have a lower hazard to default. Our results are consistent with models of sunk cost fallacy.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"20 5-6 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-08-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"116714498","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer’s expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer’s expectation management, our theory provides a rationale for “employment contracts” in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.
{"title":"Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion","authors":"F. Herweg, H. Karle, Daniel Müller","doi":"10.2139/ssrn.2955722","DOIUrl":"https://doi.org/10.2139/ssrn.2955722","url":null,"abstract":"We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer’s expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer’s expectation management, our theory provides a rationale for “employment contracts” in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"63 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-02-13","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"134220834","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
I study a relational contracting model, in which the agent's discount factor is fixed and known, whereas the discount factor of the principal is her private information. I find that, in the separating contract, information revelation is always immediate, whereas costly signaling continues for an extended period of time with at least some parameter values. I characterize the optimal separating contract. I find that, in the optimal contract of the "good" type, the bonus payment for high performance, the agent effort and the surplus in the relationship all increase gradually whereas the fixed wage decreases. Hence, optimal separation is characterized by "gradualism" in trade. There are numerous papers that generate similar results under the assumption of hidden information. However, the mechanism that gives rise to gradualism in my model is novel. Finally, I show that the optimal separating contract generates higher surplus than the optimal pooling contract regardless of the prior about the type of the principal.
{"title":"Building Trust in Relational Contracting","authors":"Melis Kartal","doi":"10.2139/ssrn.2395956","DOIUrl":"https://doi.org/10.2139/ssrn.2395956","url":null,"abstract":"I study a relational contracting model, in which the agent's discount factor is fixed and known, whereas the discount factor of the principal is her private information. I find that, in the separating contract, information revelation is always immediate, whereas costly signaling continues for an extended period of time with at least some parameter values. I characterize the optimal separating contract. I find that, in the optimal contract of the \"good\" type, the bonus payment for high performance, the agent effort and the surplus in the relationship all increase gradually whereas the fixed wage decreases. Hence, optimal separation is characterized by \"gradualism\" in trade. There are numerous papers that generate similar results under the assumption of hidden information. However, the mechanism that gives rise to gradualism in my model is novel. Finally, I show that the optimal separating contract generates higher surplus than the optimal pooling contract regardless of the prior about the type of the principal.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"1 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-02-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"129643475","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Pub Date : 2014-01-31DOI: 10.1108/s1569-375920140000096009
I. Mathur, I. Marcelin
Pledging collateral to secure loans is a prominent feature in financing contracts around the world. Existing theories disagree on why borrowers pledge collateral. It is even more challenging to understand why in some countries collateral coverage exceeds, e.g., 300% of the value of a loan. This study looks at the association between collateral coverage and country-level governance and various institutional proxies. It investigates the economic implications of steep collateral coverage and sketches policy options to lower ex-ante asymmetric information and ex-post agency problems. Within this framework, should a lender collect the debt forcibly on default and liquidated assets fetch prices below outstanding loan values, the lender’s loss is covered through credit insurance, which would significantly reduce the need for steep collateral coverage. This proposal may increase level of private credit, investment and growth; particularly, in a number of developing countries where collateral spread is the main inhibitor of finance.
{"title":"Unlocking Credit","authors":"I. Mathur, I. Marcelin","doi":"10.1108/s1569-375920140000096009","DOIUrl":"https://doi.org/10.1108/s1569-375920140000096009","url":null,"abstract":"Pledging collateral to secure loans is a prominent feature in financing contracts around the world. Existing theories disagree on why borrowers pledge collateral. It is even more challenging to understand why in some countries collateral coverage exceeds, e.g., 300% of the value of a loan. This study looks at the association between collateral coverage and country-level governance and various institutional proxies. It investigates the economic implications of steep collateral coverage and sketches policy options to lower ex-ante asymmetric information and ex-post agency problems. Within this framework, should a lender collect the debt forcibly on default and liquidated assets fetch prices below outstanding loan values, the lender’s loss is covered through credit insurance, which would significantly reduce the need for steep collateral coverage. This proposal may increase level of private credit, investment and growth; particularly, in a number of developing countries where collateral spread is the main inhibitor of finance.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"25 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2014-01-31","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"125466139","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This paper analyzes a dynamic lending relationship where the borrower cannot be forced to make repayments, and the lender offers long-term contracts that are imperfectly enforced and repeatedly renegotiated. No commitment and full commitment by the lender are special cases of this model where the probability of enforcement equals zero and one, respectively. I show that an increase in the degree of enforcement can lower social welfare. Furthermore, properties of equilibrium investment dynamics with partial commitment drastically differ from those with full and no commitment. In particular, investment is positively related to cash flow, consistent with empirical findings.
{"title":"Debt Contracts with Partial Commitment","authors":"Natalia Kovrijnykh","doi":"10.1257/AER.103.7.2848","DOIUrl":"https://doi.org/10.1257/AER.103.7.2848","url":null,"abstract":"This paper analyzes a dynamic lending relationship where the borrower cannot be forced to make repayments, and the lender offers long-term contracts that are imperfectly enforced and repeatedly renegotiated. No commitment and full commitment by the lender are special cases of this model where the probability of enforcement equals zero and one, respectively. I show that an increase in the degree of enforcement can lower social welfare. Furthermore, properties of equilibrium investment dynamics with partial commitment drastically differ from those with full and no commitment. In particular, investment is positively related to cash flow, consistent with empirical findings.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"72 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2013-12-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"133094597","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
For the classic agency model (Holmstrom, 1979), under different assumptions, we offer a completely different solution than the standard solution in the literature. Our optimal contract has a closed form, offers a contingent fixed payment, and is efficient. In contrast, the standard contract in the literature is implicitly determined by four equations except for one special case, is based on the unreliable first-order approach, and is inefficient.
{"title":"Contingent Fixed Contracts - An Alternative to the Classic Agency Theory","authors":"Susheng Wang","doi":"10.2139/ssrn.2336193","DOIUrl":"https://doi.org/10.2139/ssrn.2336193","url":null,"abstract":"For the classic agency model (Holmstrom, 1979), under different assumptions, we offer a completely different solution than the standard solution in the literature. Our optimal contract has a closed form, offers a contingent fixed payment, and is efficient. In contrast, the standard contract in the literature is implicitly determined by four equations except for one special case, is based on the unreliable first-order approach, and is inefficient.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"71 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2013-09-04","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"125286653","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This paper studies the problem of random assignment with fractional endowments. Fractional endowments complicate matters because the assignment has to make an agent weakly better off than his endowment. I first formulate an exchange economy that resembles the random assignment problem and prove the existence of competitive equilibrium in this economy. I then propose a pseudo-market mechanism for the random assignment problem that is based on the competitive equilibrium. This mechanism is individually rational, Pareto Optimal and justified envy-free but not incentive compatible.
{"title":"Competitive Equilibrium in the Random Assignment Problem","authors":"Phuong Le","doi":"10.2139/ssrn.2651963","DOIUrl":"https://doi.org/10.2139/ssrn.2651963","url":null,"abstract":"This paper studies the problem of random assignment with fractional endowments. Fractional endowments complicate matters because the assignment has to make an agent weakly better off than his endowment. I first formulate an exchange economy that resembles the random assignment problem and prove the existence of competitive equilibrium in this economy. I then propose a pseudo-market mechanism for the random assignment problem that is based on the competitive equilibrium. This mechanism is individually rational, Pareto Optimal and justified envy-free but not incentive compatible.","PeriodicalId":285784,"journal":{"name":"ERN: Economics of Contract: Theory (Topic)","volume":"423 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2013-08-26","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"116169741","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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