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  4. Preliminary Program
  5. On Moral Hazard and Adverse Selection
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On Moral Hazard and Adverse Selection

Paper Session

Saturday, Jan. 8, 2022 10:00 AM - 12:00 PM (EST)

Hosted By: American Economic Association
  • Chair: Pierre A. Chiappori, Columbia University

The Informed Principal with Agent Moral Hazard

Daniel Clark
,
Massachusetts Institute of Technology

Abstract

We study principal-agent settings where the principal has private information, both the principal and agent take actions, and the agent's action is subject to moral hazard. Unlike past work focusing on explicit contracts, we allow the principal to propose contracts that give them flexibility in their choice of future actions. We develop an adaptation of sequential equilibrium called "contracting equilibrium" for our principal-agent games, and prove its existence. In environments where the principal's type and agent's action are complements, we also apply a refinement called "payoff-plausibility." The "principal-optimal safe outcomes," which are analogs of the least-cost separating outcomes of signaling games, are always contracting equilibrium outcomes. They also provide an important payoff benchmark: Every principal type must obtain a weakly higher payoff from any payoff-plausible equilibrium. Moreover, if there are complementarities between the principal's type and their action, payoff-plausibility selects the principal-optimal safe outcomes when the principal is restricted to offering "deterministic" mechanisms. Otherwise, pooling between principal types can survive payoff-plausibility, and is more prevalent than would be predicted with explicit contracts.

Loss Aversion, Moral Hazard, and Stochastic Contracts

Hoa Ho
,
Ludwig Maximilian University of Munich

Abstract

I examine whether stochastic contracts benefit the principal in the setting of moral hazard and loss aversion. Incorporating the agent’s expectation-based loss aversion and allowing the principal to add noise to performance signals, I find that stochastic contracts reduce the principal's implementation cost in comparison to deterministic contracts. The optimal stochastic contract pays a high wage not only when good signals are realized, but also with a positive probability after the realization of bad signals. Surprisingly, if performance signals are highly informative about the agent's action, stochastic contracts strictly dominate the optimal deterministic contract for almost any degree of loss aversion. The findings have an important implication for designing contracts for loss-averse agents: the principal should insure the agent against wage uncertainty by employing stochastic contracts that increase the probability of a high wage.

Financing a Black Box: Dynamic Investment with Persistent Private Information

Felix Zhiyu Feng
,
University of Washington

Abstract

This paper studies the implication of persistent private information on a firm’s optimal financing and investment policies. In a dynamic agency model, an investor supplies capital to an entrepreneur with an opaque production technology. The entrepreneur can generate private benefit from misreporting his productivity, which bear a persistent negative effect on future productivity growth. Compared to standard agency-based investment models, the persistency of the agency friction rationalizes over-investment especially among firms with a strong history of cash flow but a low Tobin’s q, and reconciles the optimal financing policy with the empirical observations of a strong investment-cash-flow sensitivity and a weak or even negative investment-q sensitivity.

Gaming a Selective Admissions System

Frances Xu Lee
,
Loyola University Chicago
Wing Suen
,
University of Hong Kong

Abstract

Costly manipulation to gain selective admission exhibits strategic complementarity when the admissions quota is loose but strategic substitution when the quota is tight. In a system with two layers of selection, gaming at the university entrance stage can induce a university to give preferential treatment to students from a selective high school, justifying why this school attracts better talent and causing gaming to unravel to the high school entrance stage. We apply this framework to evaluate the impacts of raising the university quota, abolishing university entrance examination, eliminating sorting-by-ability in the high school system, and committing to low-powered selection policies.

Robust Corporate Signaling with Heterogeneous Beliefs

Thomas Rivera
,
McGill University

Abstract

We study the ability of a manager to use costly corporate signaling to reveal private information about firm characteristics prior to entering a new round of equity financing. We assume that the manager and the investor that provides financing may have heterogeneous and privately known beliefs regarding the value of firm characteristics. We show that equity prices under any informative signaling scheme must necessarily rely on the investor's perceived distribution of managerial beliefs. Therefore, incentive compatibility of signaling requires the manager to form precise beliefs regarding their prospective investor's higher order beliefs. Given the practical difficulty of forming correct beliefs regarding the higher order beliefs of other agents, we study robust signaling which remains incentive compatible for all higher order beliefs of the investor. Any robust disclosure mechanism is completely uninformative casting doubt on the efficacy of dynamic corporate signaling.
JEL Classifications
  • D8 - Information, Knowledge, and Uncertainty