The Value of Informativeness for Contracting

Alex Edmans, Daniel Gottlieb () and Pierre Chaigneau

No 10180, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: The informativeness principle demonstrates qualitative benefits to increasing signal precision. However, it is difficult to quantify these benefits -- and compare them against the costs of precision -- since we typically cannot solve for the optimal contract and analyze how it changes with informativeness. We consider a standard agency model with risk-neutrality and limited liability, where the optimal contract is a call option. The direct effect of reducing signal volatility is a fall in the value of the option, benefiting the principal. The indirect effect is a change in the agent's effort incentives. If the original option is sufficiently out-of-the-money, the agent can only beat the strike price if he exerts effort and there is a high noise realization. Thus, a fall in volatility reduces effort incentives. As the agency problem weakens, the gains from precision fall towards zero, potentially justifying pay-for-luck.

Keywords: Contract theory; Informativeness principle; Limited liability; Options; Pay-for-luck; Relative performance evaluation; Principal-agent model (search for similar items in EconPapers)
JEL-codes: D86 J33 (search for similar items in EconPapers)
Date: 2014-10
New Economics Papers: this item is included in nep-cta, nep-hrm and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Working Paper: The value of informativeness for contracting (2014)
Working Paper: The Value of Informativeness for Contracting (2014)
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