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Flexible Contracts

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Author Info

  • Piero Gottardi
  • Jean Marc Tallon
  • Paolo Ghirardato

Abstract

This paper studies the costs and benefits of delegating decisions to superiorly informed agents relative to the use of rigid, non discretionary contracts. Delegation grants some flexibility in the choice of the action by the agent, but also requires the use of an appropriate incentive contract so as to realign his interests with those of the principal. The parties’ understanding of the possible circumstances in which actions will have to be chosen and their attitude towards risk and uncertainty play then an important role in determining the costs of delegation. The main focus of the paper lies indeed in the analysis of these costs and the consequences for whether or not delegation is optimal.We determine and characterize the properties of the optimal flexible contract both when the parties have sharp probabilistic beliefs over the possible events in which the agent will have to act and when they only have a set of such beliefs. We show that the higher the agent’s degree of risk aversion, the higher the agency costs for delegation and hence the less profitable is a flexible contract versus a rigid one. The agent’s imprecision aversion in the case of multiple priors introduces another, additional agency costs; it again implies that the higher the degree of imprecision aversion the less profitable flexible contracts versus rigid ones. Even though, with multiple priors, the contract may be designed in such a way that principal and agent end up using ’different beliefs’ and hence engage in speculative trade, this is never optimal, in contrast with the case where the parties have sharp heterogeneous beliefs.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2927.

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Date of creation: 2010
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Handle: RePEc:ces:ceswps:_2927

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Keywords: delegation; flexibility; agency costs; multiple priors; imprecision aversion;

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References

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  1. Antoine Billot & Alain Chateauneuf & Itzhak Gilboa & Jean-Marc Tallon, 2000. "Sharing Beliefs: Between Agreeing and Disagreeing," Econometrica, Econometric Society, vol. 68(3), pages 685-694, May.
  2. Mark Armstrong & John Vickers, 2010. "A Model of Delegated Project Choice," Econometrica, Econometric Society, vol. 78(1), pages 213-244, 01.
  3. Sujoy Mukerji & Peter Klibanoff, 2002. "A Smooth Model of Decision,Making Under Ambiguity," Economics Series Working Papers 113, University of Oxford, Department of Economics.
  4. Jullien, Bruno & Salanié, Bernard & Salanié, François, 1999. "Should More Risk-Averse Agents Exert More Effort ?," Open Access publications from University of Toulouse 1 Capitole http://neeo.univ-tlse1.fr, University of Toulouse 1 Capitole.
  5. Philippe Aghion & Jean Tirole, 1994. "Formal and Real Authority in Organizations," Working papers 95-8, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. Ricardo Alonso & Niko Matouschek, 2008. "Optimal Delegation," Review of Economic Studies, Wiley Blackwell, vol. 75(1), pages 259-293, 01.
  7. Gajdos, T. & Hayashi, T. & Tallon, J.-M. & Vergnaud, J.-C., 2008. "Attitude toward imprecise information," Journal of Economic Theory, Elsevier, vol. 140(1), pages 27-65, May.
  8. Oliver Hart & John Moore, 2007. "Contracts as Reference Points," ESE Discussion Papers 170, Edinburgh School of Economics, University of Edinburgh.
  9. Eliaz, Kfir & Spiegler, Ran, 2005. "A Mechanism-Design Approach to Speculative Trade," CEPR Discussion Papers 5434, C.E.P.R. Discussion Papers.
  10. Mukerji, Sujoy, 1998. "Ambiguity Aversion and Incompleteness of Contractual Form," American Economic Review, American Economic Association, vol. 88(5), pages 1207-31, December.
  11. Ghirardato, Paolo & Maccheroni, Fabio & Marinacci, Massimo, 2004. "Differentiating ambiguity and ambiguity attitude," Journal of Economic Theory, Elsevier, vol. 118(2), pages 133-173, October.
  12. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  13. David Schmeidler, 1989. "Subjective Probability and Expected Utility without Additivity," Levine's Working Paper Archive 7662, David K. Levine.
  14. Canice Prendergast, 2002. "The Tenuous Trade-off between Risk and Incentives," Journal of Political Economy, University of Chicago Press, vol. 110(5), pages 1071-1102, October.
  15. Jewitt, Ian, 1987. "Risk Aversion and the Choice between Risky Prospects: The Preservation of Comparative Statics Results," Review of Economic Studies, Wiley Blackwell, vol. 54(1), pages 73-85, January.
  16. Strzalecki, Tomasz & Werner, Jan, 2011. "Efficient allocations under ambiguity," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1173-1194, May.
  17. Dessein, Wouter, 2002. "Authority and Communication in Organizations," Review of Economic Studies, Wiley Blackwell, vol. 69(4), pages 811-38, October.
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