Tournament Rewards and Risk Taking

I consider two seemingly unrelated puzzles; 1.Why is relative performance evaluation (RPE) used less in CEO compensation than agency theory suggests? 2.Why is sometimes, e.g., for fund managers, a mediocre performance more highly rewarded than excellence? I consider a simple tournament model, where agents can influence the spread of output in addition to its mean. I show that standard tournament rewards induce risky and lazy behavior from the agents. This finding sheds light on Puzzle 1. Second, I consider a scheme that ranks agents according to their relative closeness to a benchmar k. I show that there exists intermediate values of k such that the risky-lazy problem of the standard tournament can be mitigated. This result sheds light on Puzzle 2.

Management of Knowledge Workers

Peer reviewedPreprin

A Theory of Capital Structure with Strategic Defaults and Priority Violations

We reformulate the classic CSV model of financial contracting from Townsend (1979) and Gale & Hellwig (1985) to tackle criticisms raised against it voiced by Hart (1995), such as lack of optimal behavior at the repayment stage and an inability to allow for outside equity. As a result, we obtain a theory of capital structure that accommodates empirical regularities such as bankruptcies, strategic defaults of debt obligations, and violations of absolute priority rules as parts of the equilibrium description.Cash Diversion, Costly State Verification, Outside Equity, Financial Contracts.

Worker Discretion and Misallocation of Talent within Firms

We develop a theory of worker discretion over task choice within a firm. Increasing the workers’ discretion has a trade-off between the gains from workers using private information about their abilities, and the costs from adverse selection within the firm due to workers herding into prestigious tasks. The theory leads to the result that, in line with the Peter Principle, misallocation of talent within firms takes the form of too many workers undertaking tasks with a high return to ability. Moreover we find that the degree of misallocation of talent is decreasing in the degree of discretion given to workers.Authority, Bureaucracies, Career Concerns, Discretion, Organizational Design, Misallocation, Peter Principle, Principal-Agent Theory, Sun Hydraulics, Wage Dynamics

Pairwise Interaction on Random Graphs

We analyze dynamic local interaction in population games where the local interaction structure (modeled as a graph) can change over time: A stochastic process generates a random sequence of graphs. This contrasts with models where the initial interaction structure (represented by a deterministic graph or the realization of a random graph) cannot change over time.

Exchange-Rate Regimes: "Does What Countries Say Matter?"

Traditionally the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions has been the main source of information about the exchange-rate policies pursued by member countries. The classification contained therein has been used to document the evolution of exchange rate regimes over time as well as to study the relationship between economic performance and the choice of exchange rate system. Recently a number of authors have challenged the results of these studies on the grounds that countries may not always be following the exchange rate policy that they have announced. For example, many countries appear to have a 'fear of floating' in the sense that the evolution of their exchange rate corresponds to what one would expect to see in a fixed exchange rate country even though they are officially following a floating rate policy. New classifications have been created claiming to represent countries' actual exchange rate policy as opposed to their declared policy. Using the new classification many results relating to the evolution of exchange rate regimes and the economic consequences of exchange-rate regime choices have been overturned. It is sometimes claimed that the new so-called de facto classifications are superior to the older de jure classifications. In this paper we argue that neither the officially declared exchange rate regime nor the de facto regime tells the full story about exchange rate policy. Both contain useful information and need to be taken into account. In addition we argue that countries which claim to be floating but in fact have relatively stable exchange rates are not necessarily breaking any commitment as sometimes has been suggested. Exchange rate stability may be the result of optimally chosen monetary policies. Furthermore, countries that use monetary policy instruments actively to stabilize their exchange rate may rationally not want to announce and commit to a fixed exchange rate because of a fear of being subject to speculative attacks. We present some empirical evidence consistent with this interpretation.International Economics; Exchange Rates; Trade; Whatever Related

A Theory of Capital Structure with Strategic Defaults and Priority Violations

Why do firms delegate job design decisions to workers and what are the implications of such delegation? We develop a private-information based theory of delegation where delegation provides a more efficient allocation of talent inside the firm, but at the cost that low ability workers must be compensated to self-sort. Career concerns limit the effectiveness of delegation: when returns to ability or market observability of job content are high, the compensation needed to get low-ability workers to self-sort is high, and firms limit delegation to avoid cream-skimming of the high-ability workers. We investigate implications for how misallocation of talent within firms may occur, the optimal design of incentive contracts, and which decisions are more likely to be delegated to subordinates.Cash Diversion, Costly State Verification, Outside Equity, Financial Contracts.