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Sharp and Diffuse Incentives in Contracting

Author

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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
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    File URL: http://purl.umn.edu/151183
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    References listed on IDEAS

    as
    1. Pascal Courty & Gerald Marschke, 2004. "An Empirical Investigation of Gaming Responses to Explicit Performance Incentives," Journal of Labor Economics, University of Chicago Press, vol. 22(1), pages 23-56, January.
    2. Elizabeth Webster & Glenys Harding, 2001. "Outsourcing Public Employment Services: The Australian Experience," Australian Economic Review, The University of Melbourne, Melbourne Institute of Applied Economic and Social Research, vol. 34(2), pages 231-242.
    3. Chambers,Robert G. & Quiggin,John, 2000. "Uncertainty, Production, Choice, and Agency," Cambridge Books, Cambridge University Press, number 9780521622448.
    4. J. A. Mirrlees, 1999. "The Theory of Moral Hazard and Unobservable Behaviour: Part I," Review of Economic Studies, Oxford University Press, vol. 66(1), pages 3-21.
    5. Baker, George P, 1992. "Incentive Contracts and Performance Measurement," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 598-614, June.
    6. Simon Burgess & Marisa Ratto, 2003. "The Role of Incentives in the Public Sector: Issues and Evidence," The Centre for Market and Public Organisation 03/071, Department of Economics, University of Bristol, UK.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    incentives; contracts; arbitrage; Risk and Uncertainty; D81; D86;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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