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Sharp and Diffuse Incentives in Contracting

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  • Menezes, Flavio
  • Quiggin, John

Abstract

This paper investigates the optimality of sharp incentives in contracts where output prices are set at the time of contracting but are random in nature. It shows that when prices are specified with error, schemes involving sharp incentives might result in substantial deviations from first-best output levels. The randomness of prices creates arbitrage opportunities that are exploited by agents producing phenomena such as "cost-shifting". Both linear and piece-wise linear contracts are shown to be subject to the possibility of arbitrage. The paper then demonstrates that incentive schemes that are arbitrage-proof exhibit "diffuse" incentives.

Suggested Citation

  • Menezes, Flavio & Quiggin, John, 2007. "Sharp and Diffuse Incentives in Contracting," Risk and Sustainable Management Group Working Papers 151183, University of Queensland, School of Economics.
    • Handle: RePEc:ags:uqsers:151183
    DOI: 10.22004/ag.econ.151183
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    References listed on IDEAS

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