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Common Shocks and Relative Compensation Schemes

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  • Martine Quinzii
  • Michael Magill

    (Department of Economics, University of California Davis)

Abstract

This paper studies qualitative properties of an optimal contract in a multi-agent setting in which agents are subject to a common shock. We derive a necessary and sufficient condition for the optimal reward of an agent to be a decreasing (increasing) function of the outputs of the other agents, under the assumption that the agents' outputs are informative signals of the value of the common shock. The condition is that the likelihood ratio of a given outcome with high versus low effort be a decreasing (increasing) function of the common shock. We derive conditions on the way the common shock affects the marginal product of effort under which the likelihood ratio is decreasing for all output levels, or increasing for some output levels and decreasing for others.

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Bibliographic Info

Paper provided by University of California, Davis, Department of Economics in its series Working Papers with number 52.

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Length: 13
Date of creation: 11 Apr 2005
Date of revision:
Handle: RePEc:cda:wpaper:05-2

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Keywords: optimal incentive contracts; common shocks; multi agents; monotone likelihood ratio;

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References

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  1. Lazear, Edward P & Rosen, Sherwin, 1981. "Rank-Order Tournaments as Optimum Labor Contracts," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 841-64, October.
  2. Rogerson, William P, 1985. "The First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 53(6), pages 1357-67, November.
  3. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  4. Mookherjee, Dilip, 1984. "Optimal Incentive Schemes with Many Agents," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 433-46, July.
  5. Paul R. Milgrom, 1979. "Good Nevs and Bad News: Representation Theorems and Applications," Discussion Papers 407R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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