Principal-Agent Settings with Random Shocks

Using a gift exchange experiment, we show that the ability of reciprocity to overcome incentive problems inherent in principal-agent settings is greatly reduced when the agent’s effort is distorted by random shocks and transmitted imperfectly to the principal. Specifically, we find that gift exchange contracts without shocks encourage effort and wages well above standard predictions. However, the introduction of random shocks reduces wages and effort, regardless of whether the shocks can be observed by the principal. Moreover, the introduction of shocks significantly reduces the probability of fulfilling the contract by the agent, the payoff of the principal, and total welfare. Therefore, our findings demonstrate that random shocks place an important bound on the ability of gift exchange to overcome principal-agent problems

Principal-Agent Settings with Random Shocks

Using a gift exchange experiment, we show that the ability of reciprocity to overcome incentive problems inherent in principal-agent settings is greatly reduced when the agent’s effort is distorted by random shocks and transmitted imperfectly to the principal. Specifically, we find that gift exchange contracts without shocks encourage effort and wages well above standard predictions. However, the introduction of random shocks reduces wages and effort, regardless of whether the shocks can be observed by the principal. Moreover, the introduction of shocks significantly reduces the probability of fulfilling the contract by the agent, the payoff of the principal, and total welfare. Therefore, our findings demonstrate that random shocks place an important bound on the ability of gift exchange to overcome principal-agent problems

Dynamic Managerial Compensation: a Mechanism Design Approach

We characterize the optimal incentive scheme for a manager who faces costly effort decisions and whose ability to generate profits for the firm varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent's productivity. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the firm's profits. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justification for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the firm. In contrast to other explanations proposed in the literature (e.g., declining disutility of effort or career concerns), the optimality of seniority-based reward schemes is not driven by variations in the agent's preferences or in his outside option. It results from an optimal allocation of the manager's informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. We find that, other things equal, risk-aversion reduces the benefit of inducing higher effort over time. Whether (risk-averse) managers with a longer tenure receive more or less high-powered incentives than younger ones then depends on the interaction between the degree of risk aversion and the dynamics of the impulse responses for the shocks to the manager's type.dynamic mechanism design; adverse selection; moral hazard; incentives; optimal pay scheme; risk-aversion; stochastic process

Beauty Contests and "Irrational Exuberance": A Neoclassical Approach

The arrival of new, unfamiliar, investment opportunities is often associated with "exuberant" movements in asset prices and real economic activity. During these episodes of high uncertainty, financial markets look at the real sector for signals about the profitability of the new investment opportunities, and vice versa. In this paper, we study how such information spillovers impact the incentives that agents face when making their real economic decisions. On the positive front, we find that the sensitivity of equilibrium outcomes to noise and to higher-order uncertainty is amplified, exacerbating the disconnect from fundamentals. On the normative front, we find that these effects are symptoms of constrained inefficiency; we then identify policies that can improve welfare without requiring the government to have any informational advantage vis-a-vis the market. At the heart of these results is a distortion that induces a conventional neoclassical economy to behave as a Keynesian "beauty contest" and to exhibit fluctuations that may look like "irrational exuberance" to an outside observer.Incomplete information, beauty contests, exuberance, informational frictions, endogenous complementarities JEL Classification Numbers: C72, D62, D82

Dynamic Mechanism Design: Incentive Compatibility, Profit Maximization and Information Disclosure

This paper examines the problem of how to design incentive-compatible mechanisms in environments in which the agents' private information evolves stochastically over time and in which decisions have to be made in each period. The environments we consider are fairly general in that the agents' types are allowed to evolve in a non-Markov way, decisions are allowed to affect the type distributions and payoffs are not restricted to be separable over time. Our first result is the characterization of a dynamic payoff formula that describes the evolution of the agents' equilibrium payoffs in an incentive-compatible mechanism. The formula summarizes all local first-order conditions taking into account how current information affects the dynamics of expected payoffs. The formula generalizes the familiar envelope condition from static mechanism design: the key difference is that a variation in the current types now impacts payoffs in all subsequent periods both directly and through the effect on the distributions of future types. First, we identify assumptions on the primitive environment that guarantee that our dynamic payoff formula is a necessary condition for incentive compatibility. Next, we specialize this formula to quasi-linear environments and show how it permits one to establish a dynamic "revenue-equivalence" result and to construct a formula for dynamic virtual surplus which is instrumental for the design of optimal mechanisms. We then turn to the characterization of sufficient conditions for incentive compatibility. Lastly, we show how our results can be put to work in a variety of applications that include the design of profit-maximizing dynamic auctions with AR(k) values and the provision of experience goods.dynamic mechanisms, asymmetric information, stochastic processes, incentives

Progressive learning

We study a dynamic principal–agent relationship with adverse selection and limited commitment. We show that when the relationship is subject to productivity shocks, the principal may be able to improve her value over time by progressively learning the agent's private information. She may even achieve her first‐best payoff in the long run. The relationship may also exhibit path dependence, with early shocks determining the principal's long‐run value. These findings contrast sharply with the results of the ratchet effect literature, in which the principal persistently obtains low payoffs, giving up substantial informational rents to the agent

Socially Optimal Coordination: Characterization and Policy Implications

In recent years there has been a growing interest in macro models with heterogeneity in information and complementarity in actions. These models deliver promising positive properties, such as heightened inertia and volatility. But they also raise important normative questions, such as whether the heightened inertia and volatility are socially undesirable, whether there is room for policies that correct the way agents use information in equilibrium, and what are the welfare effects of the information disseminated by the media or policy makers. We argue that a key to answering all these questions is the relation between the equilibrium and the socially optimal degrees of coordination. The former summarizes the private value from aligning individual decisions, whereas the latter summarizes the value that society assigns to such an alignment once all externalities are internalized.Dispersed information, coordination, complementarities, volatility, inertia, efficiency

A System Dynamics Model of Cyclical Office Oversupply

This article explores office market system dynamics through a simple simulation model. Model lag and adjustment parameters similar to real office markets generate explosive cycles. Simulations show that deviations from equilibrium can be reduced by changing the information structure of the system. System dynamics, principle/agent conflicts, a prisoners’ dilemma game, faulty information (poor forecasting, market research and valuation techniques), regulatory institutions, and differing equilibria in office space and financial markets all contribute to allocative inefficiency. Thinking of office markets as a "managed feedback control system" may be a useful representation of the oversupply problem. Leverage points for system improvement may be a municipal "queue" to address agency and prisoner's dilemma problems, improved forecasting techniques and more reliance on forecasting.

Mixed Tournaments, Common Shocks, and Disincentives: An Experimental Study

Two well-known hypotheses from the literature on tournaments are that (1) tournaments can filter out common shocks thereby reducing agents risk exposure; and (2) disincentive effects can arise when a tournament scheme is administered on a group of mixed ability agents. While handicapping and/or the creation of homogeneous groups have been suggested as mechanisms for mitigating disincentive effects, it is often impractical to use handicapping schemes and nearly impossible to create a completely homogeneous labor force. Hence, contract administrators who intend to use tournaments to elicit effort must be able to assess the positive effects of tournaments (eliminate common shocks) against the negative effects (disincentive effects). Using economic experiments, we find evidence of disincentive effects under tournaments, although these effects are not as strong as predicted. Moreover, tournaments can be effective at reducing earnings variability when common shocks are important. These results suggest that the benefits of risk reduction from eliminating common shocks might outweigh the disincentive effects arising from mixed tournaments.mixed tournaments, incentives, relative performance contracts, experimental economics, Research Methods/ Statistical Methods, C91 D01, D81, D82, D86,

Globalization and Trust: Theory and Evidence from Cooperatives

We study the effect of globalization on the stock of trust in organizations. We present a simple model of endogenous trust and show that contrary to centralized hierarchies (pure limited liability firms), decentralized organizational structures (cooperatives) foster the emergence of trust. We treat organizations as directly observable ‘summary statistics’ for underlying trust and ask what will be the fate of trust as the world becomes increasingly globalized. Because the cooperative is an intrinsically less efficient organizational form and globalization implies harsher competitive pressures, conventional wisdom suggests that the viability of cooperatives is in jeopardy. We show that this is not necessarily true. If the increase in competition is bundled with an increase in uncertainty and risk, the cooperative may become a more efficient organizational form. We conclude that globalization does not necessarily erode trust. The case of Mondragón Corporación Cooperativa is used to motivate assumptions and illustrate the results.http://deepblue.lib.umich.edu/bitstream/2027.42/39978/3/wp592.pd