Limited Liability and Option Contracts in Models with Sequential Investments

The paper investigates a model where two parties sequentially invest in a joint project (an asset). Investments and the project value are unverifiable, and A is wealth constrained so that an initial outlay must be financed by either agent B or an external investor C, say a bank. We show that an option contract in combination with a loan arrangement facilitates first best investments and any distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, the first best can still be attained unless A's bargaining position is too strong. Otherwise, B financing or C financing may become strictly preferable, and a combination of multiple lenders may be optimal.Option Contracts, Corporate Finance, Sequential Investments, Double Moral Hazard

Reforming an Asymmetric Union: On the Virtues of Dual Tier Capital Taxation

The tax competition for mobile capital, in particular the reluctance of small countries to agree on measures of tax coordination, has ongoing political and economic fallouts within Europe. We analyse the effects of introducing a two tier structure of capital taxation, where the asymmetric member states of a union choose a common, federal tax rate in the first stage, and then non-cooperatively set local tax rates in the second stage. We show that this mechanism effectively reduces competition for mobile capital between the members of the union. Moreover, it distributes the gains across the heterogeneous states in a way that yields a strict Pareto improvement over a one tier system of purely local tax choices. Finally, we present simulation results, and show that a dual structure of capital taxation has advantages even when side payments are feasible

The Theory of Human Capital Revisited: On the Interaction of General and Specific Investments

Human capital theory distinguishes between training in general-usage and firm-specific skills. In his seminal work, Becker (1964) argues that employers will not be willing to invest in general training when labor markets are competitive. However, they are willing to invest in specific training because it cannot be transferred to outside firms. The paper reconsiders Becker’s theory. We show that there exists an incentive complementarity between employersponsored general and specific investments: the possibility to provide specific training leads the employer to invest in general human capital. Conversely, the latter reduces the hold-up problem that arises with respect to the provision of firm-specific training. We also consider the virtues of long-term contracting and discuss some empirical observations that could be explained by the model.human capital formation, general and specific training, hold-up problem.

Voluntary Equity, Project Risk, and Capital Requirements

We introduce a model of the banking sector that formally incorporates a buffer function of capital. Heterogeneous banks choose their portfolio risk, bank size, and capital holdings. Banks voluntarily hold equity when the buffer effect against the risk of default outweighs the cost advantages of debt financing. In this setting, banks with lower monitoring costs are larger, choose riskier portfolios, and have less equity. Moreover, binding capital requirements or levies on bank borrowing are shown to make higher-risk portfolios more attractive. Accounting for banks' interior capital choices can thus explain why higher capital ratios incentivize banks to undertake riskier projects

Holdups, Quality Choice, and the Achilles' Heel in Government Contracting

This paper investigates a procurement relationship between a welfare-oriented government and a private supplier. The agents face several versions of the trading good which differ in quality and production costs, and the differences between those items are undescribable ex ante. In presence of this `quality-choice problem', no initial contract may induce efficient cost-reducing investments of the supplier. In contrast, a first-best result is always attainable in private procurement where the buyer maximizes profit rather than welfare. We identify the government's welfare objective as its Achilles' heel: equilibrium trade prices differ in public and private procurement, and private governance can lead to more efficient investment decisions even though renegotiation ensures the ex-post efficient trade decision in either regime.Procurement, Incomplete Contracts, Quality Choice, Governance Structure

Optimal Contracting with Verifiable Ex Post Signals

We study an adverse selection problem in which information that is imperfectly correlated with the agent's type becomes public ex post. Unbounded penalties are ruled out by assuming that the agent is wealth constrained. The following conclusions emerge. If the agent's utility is increasing in the contractual action (e.g. the quantity traded), the downward distortion in bad states may be strengthened. Hence, ex post information can reduce efficiency. In contrast, if the agent's utility is decreasing in the action level, there may be an upward distortion. Moreover, his rent may increase due to the ex post signal about his type. The qualitative results thus differ substantially depending on the specific situation under consideration, e.g., whether the agent is in a `buyer' or `seller' position. In both cases, however, additional information need not improve the efficiency of the relationship.Adverse Selection; Ex Post Information; Wealth Constraints; Upward Distortion

Strategic Defection in Bilateral Trade

The paper studies a generic bilateral trade model with relationship-specific investments. Only the seller invests, and subsequent trade becomes inefficient if his investments are too low. We show that the seller may defect strategically under a fixed-price contract even though he attains any arbitrary surplus when expending the (second-best) investment. In this case, no general mechanism facilitates trade and the parties should not start their relationship. Also, the defection problem may be more severe when the parties trade after the buyer's valuation has been disclosed, as compared to a situation where the parties have to complete trade under uncertainty.Bilateral Trade, Hold-Up, Specific Investments, Incomplete Contracts

Team Production, Sequential Investments and Stochastic Payoffs

We investigate a team production problem where two parties sequentially invest to generate a joint surplus. In this framework, it is possible to implement the first best even if the investment return is highly uncertain. The optimal contract entails a basic dichotomy: it is a simple option contract if the investments of both parties are substitutive, and a linear incentive contract if they are complementary. These schemes can be interpreted in terms of asset ownership: for the case of substitutive investments, a conditional ownership structure is optimal while for complementary investments shared equity in combination with a bonus component renders efficiency feasible. In either case, the parties renegotiate the initial arrangement after the first party invested.Team Production, Asset Ownership, Sequential Investments

Central Governance or Subsidiarity: A Property-Rights Approach to Federalism

The paper reconsiders the theory of fiscal federalism in a framework inspired by property-rights theory. We set up a two-period model where on a first stage a region in a federation can expend value-enhancing investments into a public project. The project can be implemented on a second stage, and causes spilovers on other regions. Under centralized as well as decentralized governance, negotiations on the federal level facilitate the realization of the efficient policy. Still, non-contractibility of investments causes the overall outcomes to differ across regimes. If the region with access to the public project bears the entire implementation costs of its policies, underinvestment prevails and subsidiarity (centralized governance) is superior when spillovers are weak (strong). Conversely, if linear cost-sharing arrangements are feasible, decentralized authority often leads to a socially optimal outcome while centralized authority (with majority or unanimity rule) does not.Federalism, Property Rithts, Grants