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Endogenous Contractual Externalities

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  • Yuan, Kathy
  • Ozdenoren, Emre

Abstract

We study ffort and risk-taking behaviour in an economy with a continuum of principal-agent pairs where each agent exerts costly hidden effort. When the industry productivity is uncertain, agents have motivations to match the industry average effort, which results in contractual externalities. Contractual externalities have welfare changing effects when the information friction is correlated and the industry risk is not revealed. This is because principals do not internalize the impact of their choice on other principals' endogenous industry risk exposure. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivise their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks relative to the second best. The opposite occurs when the expected productivity is low.

Suggested Citation

  • Yuan, Kathy & Ozdenoren, Emre, 2014. "Endogenous Contractual Externalities," CEPR Discussion Papers 10052, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10052
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    More about this item

    Keywords

    Contractual externalities; Relative and absolute performance contracts; Boom-bust effort exertion; Risk taking;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G01 - Financial Economics - - General - - - Financial Crises
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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