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Signaling quality with increased incentives

Author

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  • Karle, Heiko
  • Schumacher, Heiner
  • Staat, Christian

Abstract

Previous work on informed-principal problems with moral hazard suggested that the principal should signal project quality by retaining a larger share of the project and hence lowering incentives for the agent. We show that this view is incomplete. If project quality and effort are complements and effort is more valuable for high-quality projects, a principal with a high-quality project may separate from a principal with a low-quality project by increasing incentives for the agent. This holds with a risk-neutral agent who is protected by limited liability as well as with a risk-averse agent and unlimited liability. A dynamic version of our model in which the agent learns project quality in later periods provides an explanation for the use of initially reduced royalty rates in business-format franchising contracts.

Suggested Citation

  • Karle, Heiko & Schumacher, Heiner & Staat, Christian, 2016. "Signaling quality with increased incentives," European Economic Review, Elsevier, vol. 85(C), pages 8-21.
    • Handle: RePEc:eee:eecrev:v:85:y:2016:i:c:p:8-21
    DOI: 10.1016/j.euroecorev.2016.02.002
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    Citations

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    Cited by:

    1. Schumacher, Heiner & Thysen, Heidi Christina, 2022. "Equilibrium contracts and boundedly rational expectations," Theoretical Economics, Econometric Society, vol. 17(1), January.
    2. Qianqian Shi & Jianbo Zhu & Marcel Hertogh & Zhaohan Sheng, 2018. "Incentive Mechanism of Prefabrication in Mega Projects with Reputational Concerns," Sustainability, MDPI, vol. 10(4), pages 1-16, April.
    3. Teddy Mekonnen, 2021. "Informed principal, moral hazard, and limited liability," Economic Theory Bulletin, Springer;Society for the Advancement of Economic Theory (SAET), vol. 9(1), pages 119-142, April.
    4. Frances Xu Lee & Yuk‐fai Fong, 2017. "Signaling by an informed service provider," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 26(4), pages 955-968, December.

    More about this item

    Keywords

    Informed principal; Moral hazard; Signaling; Franchising; Initially reduced royalty rates;
    All these keywords.

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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