The value of informativeness for contracting

Pierre Chaigneau, Alex Edmans and Daniel Gottlieb

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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-oft 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; principal-agent model; limited liability; pay-for-luck; relative performance evaluation; options; informativeness principle (search for similar items in EconPapers)
JEL-codes: D86 J33 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2014-10-01
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http://eprints.lse.ac.uk/119024/ Open access version. (application/pdf)

Related works:
Working Paper: The Value of Informativeness for Contracting (2014)
Working Paper: The Value of Informativeness for Contracting (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119024

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