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The Value of Informativeness for Contracting

Pierre Chaigneau, Alex Edmans and Daniel Gottlieb ()

No 20542, NBER Working Papers from National Bureau of Economic Research, Inc

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.

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
Note: CF LE LS
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Working Paper: The Value of Informativeness for Contracting (2014) Downloads
Working Paper: The value of informativeness for contracting (2014) Downloads
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