Optimal contracts with contingent allocation (original) (raw)
Related papers
Optimal contracts when enforcement is a decision variable: A comment. Authors' reply
Econometrica, 2003
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. This paper analyzes choice-theoretic costly enforcement in an intertemporal contracting model with a differentially informed investor and entrepreneur. An intertemporal contract is modeled as a mechanism in which there is limited commitment to payment and enforcement decisions. The goal of the analysis is to characterize the effect of choice-theoretic costly enforcement on the structure of optimal contracts. The paper shows that simple debt is the optimal contract when commitment is limited and costly enforcement is a decision variable (Theorem 1). In contrast, stochastic contracts are optimal when agents can commit to the ex-ante optimal decisions (Theorem 2). The paper also shows that the costly state verification model can be viewed as a reduced form of an enforcement model in which agents choose payments and strategies as part of a perfect Bayesian Nash equilibrium.
Interpreting contracts: the purposive approach and non-comprehensive incentive contracts
European Journal of Law and Economics, 2020
Real world contracts often contain incentive clauses that fail to fully specify conditions triggering payments, giving rise to legal disputes. When complete contract generate Pareto efficient allocations the L&E literature advocates that courts should fill in the missing clauses. This logic does not directly extend to environments with moral hazard, where complete contracts result in constrained efficient allocations. Despite this inefficiency we find that when agency and marginal agency costs are congruent, the legal system can do no better than guide its courts to complete contracts according to the parties' intentions.
The Design of Optimal Collateralized Contracts
2016
This paper presents a two-period optimal contracting model of collateral. A borrower values a capital good and a composite non-capital good. He privately observes an income shock in the composite good in the second period. Collateralization of both goods occurs in the optimal contract, whereas it does not under full information. Relative to full information, the capital good in the optimal contract is over-consumed in the initial loan period and under-consumed in the repayment period. The relation between forfeiture of assets and contractual distortion is summarized by a formula showing higher distortions associated with larger increases in forfeited collateral. Forfeiture is decreasing in income at the tails of the income distribution, and low income types forfeit more than high income types. We obtain a closed form solution in a parameterized model. Forfeited collateral is globally decreasing in income with pooling at the bottom when the borrower's initial assets are low.
The Law and Economics of Contracts
2006
The essence of a free-market economy is the ability of private parties to enter into voluntary agreements that govern the economic exchange between them. Consequently, the law that governs such agreements is critical to the functioning of such economies. While the law of property determines the configuration of entitlements that form the basis of production and exchange, and the law of torts protects those entitlements from involuntary encroachment and expropriation, it is contract law that sets the rules for exchanging individual claims to entitlements and, thus, determines the extent to which society is able to enjoy the gains from trade. Accordingly, economists interested in the welfare properties of specific institutions in particular, or the micro-foundations of exchange generally, have good reason to take account of the law of contracts. This chapter, accordingly, surveys the main issues arising in the economic analysis of contract law. We discuss both the main features of contract law as they relate to the problem of economic exchange, and how relevant legal rules and institutions can be analyzed from an economic perspective. In this introductory section, we set out the basic scope, methodology, and organization of the discussion to follow. Subsection 1.1 discusses why formal and informal contracts exist, and what economic functions they serve. Subsection 1.2 distinguishes between positive and normative issues in the economic analysis of contract law, and discusses some methodological problems associated with applying standard economic analysis to legal institutions and when engaging with legal scholarship. Subsection 1.3 identifies limits on the chapter's scope and provides bibliographic recommendations for material we don't cover; and subsection 1.4 sets out the organization of the remainder of the chapter. A caveat is in order at the outset: although it is conventional to present contract law as a discrete field, one should understand that, to a significant extent, the operation of the rules and institutions discussed below will depend on other aspects of the law, including the fields of tort, bankruptcy, procedure, and evidence. Lawyers have a cliché that describes this interdependence; they say that "the law is a seamless web." It is useful to keep in mind that many issues that economists would regard as contractual, including some important limits on contractual freedom, are governed not by contract but by tort law. Additionally, the rules relating to certain categories of exchange, such as consumer, employment, insurance, and information-licensing contracts, have developed specialized content to the point that they are often treated as distinct legal fields. Finally, the practical ability of contracting parties to assert their legal entitlements depends importantly on the procedural rules that govern courts and other enforcement institutions. Many of the specific features of contract law that we discuss below cannot be understood except as a response to the costs and other limitations of such institutions. 1.1.3 Implementing production over time Finally, contracts are valuable in promoting production in advance of exchange. Advance production typically increases the surplus available from exchange, but requires sinking resources in ways that may be unrecoverable if the contemplated exchange is not completed. For example, a clothing manufacturer can increase Enforcement costs. It is never costless to hold a party to his commitment if he is inclined to try to escape it. If the contract is being enforced through the courts, for instance, lawyers must be hired and evidence assembled, and performance or damages are likely to be awarded only after some delay. Such costs make enforcement incredible when the damages from breach are relatively 1.2.2 Positive issues While most work on the economics of contract law has sought, at least in part, normative conclusions, there is a segment of the literature devoted to predicting and explaining how different contractual rules affect private transactions, and why contracting parties might choose one contractual device rather than others. For example, a variety of authors (e.g., Joskow, 1987; Crocker and Masten, 1988; Pirrong, 1993) have investigated the connection between the use and duration of contractual agreements and the extent of relationship-specific investments.
Optimal Contracts, Adverse Selection, and Social Preferences: An Experiment
2000
It has long been standard in agency theory to search for incentivecompatible mechanisms on the assumption that people care only about their own material wealth. However, this assumption is clearly refuted by numerous experiments, and we feel that it may be useful to consider nonpecuniary utility in mechanism design and contract theory. Accordingly, we devise an experiment to explore optimal
Linear contracts as incentives: a puzzle
Spanish Economic Review, 2007
This paper reexamines the linear schedule of compensation as a tool for providing incentives to managers when contractible output is a function of costly effort and a random shock. Two puzzling situations compatible with linear schemes of compensation are presented. First, if the model parameters are such that the optimal participation on output is below 50%, the variable compensation turns out to have a negative effect on manager's utility. Second, if it is below 25%, linear incentives allow situations in which larger utilities are reached by means of smaller rewards.
Wealth constraint and contractual arrangements
Canadian Journal of Economics/Revue canadienne d'économique, 2009
We examine how a project owner optimally selects a project operator and motivates him to deliver an unobservable effort when potential operators are wealth constrained. We show that, when potential operators' abilities are common knowledge, an operator's share of realized profit can be increasing, invariant, or decreasing in his ability depending on the nature of production technology. However, when potential operators are privately informed about both their abilities and their effort supply, a bunching contract arises in equilibrium for a general class of production technology. In the case of bunching, all potential operators are selected equally often and awarded an equal share of realized profit. The finding provides an explanation for the relative uniformity of contract terms in many practical settings. JEL classification: D440, D820, L140
Iqbal, M. and T. Khan, eds. (2005) Financial Engineering and Islamic Contracts, Palgrave Macmillan
This paper derives optimal sharing ratio under sharing contract (mudarabah). The contract then is compared to standard debt contract (riba) under symmetric and asymmetric information. It is found that, when bankruptcy costs are positive, and expected marginal gain is not less than marginal loss, aggregate expected profits from sharing exceed those of debt, under both symmetric and asymmetric information. This result holds despite that effort level is the same in both contracts.
2010
This paper studies the costs and benefits of delegating decisions to superiorly informed agents relative to the use of rigid, non discretionary contracts. Delegation grants some flexibility in the choice of the action by the agent, but also requires the use of an appropriate incentive contract so as to realign his interests with those of the principal. The parties' understanding of the possible circumstances in which actions will have to be chosen and their attitude towards risk and uncertainty play then an important role in determining the costs of delegation. The main focus of the paper lies indeed in the analysis of these costs and the consequences for whether or not delegation is optimal.