Endogenous Contractual Externalities

Kathy Yuan and Emre Ozdenoren

No 10052, CEPR Discussion Papers from Centre for Economic Policy Research

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.

Keywords: Contractual externalities; Relative and absolute performance contracts; Boom-bust effort exertion; Risk taking (search for similar items in EconPapers)
JEL-codes: D86 G01 G30 (search for similar items in EconPapers)
Date: 2014-07
New Economics Papers: this item is included in nep-cta, nep-hrm and nep-mic
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Working Paper: Endogenous contractual externalities (2015)
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