Signaling quality with increased incentives

Heiko Karle, Heiner Schumacher and Christian Staat

European Economic Review, 2016, vol. 85, issue C, 8-21

Abstract: Previous work on informed-principal problems with moral hazard suggested that the principal should signal project quality by retaining a larger share of the project and hence lowering incentives for the agent. We show that this view is incomplete. If project quality and effort are complements and effort is more valuable for high-quality projects, a principal with a high-quality project may separate from a principal with a low-quality project by increasing incentives for the agent. This holds with a risk-neutral agent who is protected by limited liability as well as with a risk-averse agent and unlimited liability. A dynamic version of our model in which the agent learns project quality in later periods provides an explanation for the use of initially reduced royalty rates in business-format franchising contracts.

Keywords: Informed principal; Moral hazard; Signaling; Franchising; Initially reduced royalty rates (search for similar items in EconPapers)
JEL-codes: D23 D82 D86 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:85:y:2016:i:c:p:8-21

DOI: 10.1016/j.euroecorev.2016.02.002

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