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Endogenous contractual externalities

Emre Ozdenoren and Kathy Yuan

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

Abstract: We study effort 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 internalise 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 and risk taking. (search for similar items in EconPapers)
JEL-codes: D86 G30 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2015-11-01
New Economics Papers: this item is included in nep-hrm and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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http://eprints.lse.ac.uk/65100/ Open access version. (application/pdf)

Related works:
Working Paper: Endogenous Contractual Externalities (2014) Downloads
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