Contracts and Mechanism Design What Contracts Accomplish Moral Hazard Adverse Selection (if time: Signaling)

What do Contracts Provide? Risk Sharing Incentives (to offset Moral Hazard) Information Revelation Examples from –Financial Institutions –Labor Markets

Risk Sharing Financial Example: Pure Insurance Contracts The simplest case: Insurer (risk neutral) Insured (risk averse)

Risk Sharing The underlying principle: Give the insured income in states of the world where income is valuable to him (“high marginal utility of income”) Have the insured give up income in states of the world in which income is less valuable (“low marginal utility of income”). In effect: Even out the insured’s net income.

Risk Sharing Labor market example: Salaries or wage contracts as insurance

Incentives Labor Market Example (Dixit-Nalebuff): Low quality effort: $120,000 value $50,000 cost of effort High quality effort: $160,000 value $70,000 cost of effort

Incentives If input (effort) observable, write contract on input. If input not observable (“moral hazard”), write contract on observable output: “Success” or “Failure”

Incentives 60% success vs. 80% success -- i.e. 20% difference so $100,000 bonus (if risk neutral employee) necessary to encourage effort.

Incentives For example: $100,000 for success and $0 for failure Or $110,000 for success and $10,000 for failure. (Absolute levels set by alternative opportunities…)

Incentives Disadvantage: Riskiness Bonus must increase if the employee is risk averse

Moral Hazard Unobservable actions by an agent affecting the probability of success or failure. Contracting on observable outcomes provides partial remedy Labor Market Example (above) Insurance Market Example: Deductibles

Moral Hazard Basic Message: Trade off between complete insurance and prevention of moral hazard The more risk averse the agent (employee or insured), the more s/he will resist risky rewards, and the more expensive it is to avoid moral hazard

Moral Hazard Corporate Finance Example: Incentives of managers affected by remuneration packages and consequences of bankruptcy Incentives of shareholders affected by leverage under financial stress

Information Revelation Selection among alternative offers Employment offers Insurance offers If offer poorly chosen, leads to “adverse selection”

Lemons

The Unifying Principle Adverse Selection: the process by which less desirable members of a population of buyers and sellers are disproportionately likely to participate in the market.

Information Revelation Evading the lemons problem: Direct vs. indirect information revelation

Signaling

Signals will only be effective if Ease of Making Signal Correlates with Value of Good.

Other examples of signaling Financial: Stock splits, dividends, spinoffs Political: “sending a message” (?)

Summary Contracts provide insurance Contracts are also fundamental to mechanism design, providing –Incentives –Information revelation Properly constructed contracts can remedy –Moral hazard –Adverse selection

Summary Investing in information provision can also reduce the costs of asymmetric information –Direct provision (certification) –Indirect provision (signaling)

Wrap up The course has applied game theory to problems of firms in competitive environments

Wrap up Game Theory –Sequential Games –Simultaneous Games –Repeated Interactions –Strategic Moves: Threats, Promises, Commitments –Unpredictability –Coordination

Wrap up Mechanism Design –Auctions Private Values: Shading Bids vs. Truthful Bidding Common Values: Winner's Curse –Contracts Moral Hazard: Tradeoff between Incentives and Risk Sharing Adverse Selection: The problem and remedies through contract design