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Flexible contracts

  • Piero Gottardi
  • Jean-Marc Tallon
  • Paolo Ghirardato

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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Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 128.

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Length: 50 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:cca:wpaper:128
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  1. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2002. "A smooth model of decision making under ambiguity," ICER Working Papers - Applied Mathematics Series 11-2003, ICER - International Centre for Economic Research, revised Apr 2003.
  2. Mukerji, Sujoy, 1998. "Ambiguity Aversion and Incompleteness of Contractual Form," American Economic Review, American Economic Association, vol. 88(5), pages 1207-31, December.
  3. Alonso, Ricardo & Matouschek, Niko, 2005. "Optimal Delegation," CEPR Discussion Papers 5289, C.E.P.R. Discussion Papers.
  4. Armstrong, Mark & Vickers, John, 2008. "A model of delegated project choice," MPRA Paper 8963, University Library of Munich, Germany.
  5. 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.
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  7. Eliaz, Kfir & Spiegler, Ran, 2005. "A Mechanism-Design Approach to Speculative Trade," CEPR Discussion Papers 5434, C.E.P.R. Discussion Papers.
  8. Ghirardato, Paolo & Maccheroni, Fabio & Marinacci, Massimo, 2004. "Differentiating ambiguity and ambiguity attitude," Journal of Economic Theory, Elsevier, vol. 118(2), pages 133-173, October.
  9. Thibault Gajdos & Takashi Hayashi & Jean-Marc Tallon & Jean-Christophe Vergnaud, 2008. "Attitude toward imprecise information," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00451982, HAL.
  10. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  11. Strzalecki, Tomasz & Werner, Jan, 2011. "Efficient allocations under ambiguity," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1173-1194, May.
  12. Oliver Hart & John Moore, 2008. "Contracts as Reference Points," The Quarterly Journal of Economics, MIT Press, vol. 123(1), pages 1-48, 02.
  13. 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.
  14. Dessein, Wouter, 2002. "Authority and Communication in Organizations," Review of Economic Studies, Wiley Blackwell, vol. 69(4), pages 811-38, October.
  15. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-87, May.
  16. 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.
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