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Flexible Contracts

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  • 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. Tomasz Strzalecki & Jan Werner, . "Efficient Allocations under Ambiguity," Working Paper 8325, Harvard University OpenScholar.
  2. Thibault Gajdos & Takashi Hayashi & Jean-Marc Tallon & Jean-Christophe Vergnaud, 2006. "Attitude toward imprecise information," Cahiers de la Maison des Sciences Economiques, Université Panthéon-Sorbonne (Paris 1) v06081, Université Panthéon-Sorbonne (Paris 1).
  3. Oliver Hart & John Moore, 2007. "Contracts as Reference Points," ESE Discussion Papers, Edinburgh School of Economics, University of Edinburgh 170, Edinburgh School of Economics, University of Edinburgh.
  4. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2002. "A smooth model of decision making under ambiguity," ICER Working Papers - Applied Mathematics Series, ICER - International Centre for Economic Research 11-2003, ICER - International Centre for Economic Research, revised Apr 2003.
  5. Antoine Billot & Alain Chateauneuf & Itzhak Gilboa & Jean-Marc Tallon, 2000. "Sharing beliefs: between agreeing and disagreeing," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00174553, HAL.
  6. Mukerji, Sujoy, 1998. "Ambiguity Aversion and Incompleteness of Contractual Form," American Economic Review, American Economic Association, American Economic Association, vol. 88(5), pages 1207-31, December.
  7. Jewitt, Ian, 1987. "Risk Aversion and the Choice between Risky Prospects: The Preservation of Comparative Statics Results," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 54(1), pages 73-85, January.
  8. Ghirardato, Paolo & Maccheroni, Fabio & Marinacci, Massimo, 2004. "Differentiating ambiguity and ambiguity attitude," Journal of Economic Theory, Elsevier, Elsevier, vol. 118(2), pages 133-173, October.
  9. Kfir Eliaz & Rani Spiegler, 2005. "A Mechanism-Design Approach to Speculative Trade," Levine's Bibliography 784828000000000429, UCLA Department of Economics.
  10. Philippe Aghion & Jean Tirole, 1994. "Normal and Real Authority in Organizations," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 94-13, Massachusetts Institute of Technology (MIT), Department of Economics.
  11. Wouter Dessein, 2002. "Authority and Communication in Organizations," Review of Economic Studies, Oxford University Press, vol. 69(4), pages 811-838.
  12. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, Econometric Society, vol. 57(3), pages 571-87, May.
  13. Ricardo Alonso & Niko Matouschek, 2008. "Optimal Delegation," Review of Economic Studies, Oxford University Press, vol. 75(1), pages 259-293.
  14. Mark Armstrong & John Vickers, 2010. "A Model of Delegated Project Choice," Econometrica, Econometric Society, Econometric Society, vol. 78(1), pages 213-244, 01.
  15. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  16. Canice Prendergast, 2002. "The Tenuous Trade-off between Risk and Incentives," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 110(5), pages 1071-1102, October.
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