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Abstract:
According to conventional wisdom, if a monopolist operates in two separate markets whose respective demand functions can be ordered by elasticity, he will charge more on the market with the less elastic demand.

In this paper we debunk the widespread canard that this follows from the first order profit maximization conditions. It is shown that, on the other hand, an inverse relationship between price and elasticity follows--with some qualifications--from the properties of the star partial ordering applied to the two demand functions. A number of related results are also given.

Abstract:
We investigate the relationship between banks' capitalization and risk-taking behavior. The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return. Finally, empirical studies on this issue provide only mixed evidence.

The aim of this article is to shed new light on this issue by expanding existing models to account for the shortcomings identified. Thus, we explicitly model three different incentives of the agents that shape risk-taking behavior in banking; regulatory bodies, shareholders, and management. We consider how the respective incentives influence the riskiness of a bank-portfolio for four distinct assumptions about the characteristics of risk-return profiles. By combining these factors, we demonstrate that a bank's risk can either decrease or increase with capitalization depending on the relative forces of the three agents in determining asset risk and on various parametric assumptions about risk-return profiles.

In the empirical study, the regression equations are modeled so that the differing incentives of the three agents are allowed to interact. The test results show differences in risk-capitalization relationships across high and low capital banks and across publicly and non-publicly traded banks. This indicates that risk-capitalization relationships are, indeed, sensitive to the relative forces of the three agents in determining asset risk.

Banks' risk, bank capitalization, option value of deposit insurance, equity value maximization, moral hazard

Abstract:
The dynamics of incentive contracts under asymmetric information have long been an important topic in economics. We address this topic in this paper by considering a stochastic, two-period principal-agent relationship, in which the true state of the world can take on two possible values and is the same in each period. We study contracts that are short term, so that after the first period the principal designs a second contract, taking the information available about the state of the world at that stage into account--that is, the standard framework in which the "ratchet effect" occurs.

Two significant changes emerge when compared to deterministic environments: First, if production is sufficiently noisy, a fully separating first period contract is optimal. The second change is that, unlike the deterministic setting where the high type's target is fixed over time, in a stochastic environment, the high type's target is ratcheted upward in the course of the interaction. This is the result of two opposing incentives of the principal: First, the principal experiments in order to increase the flow of information; and second, the principal attempts to dampen the first period signal to reduce up-front payments.

Abstract:
This paper provides a theoretical framework to investigate the relationship between banks' capitalization and risk-taking behavior. The conventional wisdom is that relatively well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases as the capital to asset ratio increases. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom: (1) Existing studies have neglected the agency problem arising from the separation of management and ownership. (2) Past studies did not consider risk-return profiles in which higher risk is associated with higher return. (3) Empirical studies on this issue provide only mixed evidence.

The aim of this paper is to shed new light on this issue by expanding existing models in two dimensions. First, by incorporating into a single model the three different incentives of three agents - the bank regulator, the shareholder, and the manager - regarding the risk determination by a bank; and second, by introducing four distinct assumptions on the characteristics of risk-return profiles. By combining these two factors, the theoretical model demonstrates that a bank's risk can either decrease or increase with capitalization depending on the relative forces of the three agents in determining asset risk and on various parametric assumptions about risk-return profiles.

Banks' risk, Moral hazard, Bank capitalization, Option value of deposit insurance, Equity value maximization, Agency, Managerial private benefit

Abstract:
We consider sequential construction contracts in which bidders may benefit from one auction to the next due to synergistic tasks across the projects auctioned. Theoretical considerations indicate that winners in the former auctions are more likely to participate in latter auctions. Moreover, conditional on participation, past winners place lower bids, on average, and are so more likely to win in later auctions. We present evidence in support of these predictions using sequential construction auctions conducted by the Oklahoma Department of Transportation.

Sequential auctions, synergies, multi-unit auctions, procurement auctions

Abstract:
In this paper, we analyze the interaction between an incumbent firm's financial contract with a bank and its product market decisions in the face of the threat of entry, in a dynamic model. The main results of the paper are: there exists a separating equilibrium with no limit pricing; there are conditions under which the low-cost incumbent repays more to the bank, due to the threat of entry; and there are parameter values for which the bank makes more profits with the threat of entry than without.

Abstract:
In many procurement auctions bidders do not know how many rivals they face at the time they incur the cost of preparing their bids. We show in a theoretical model that regardless of whether the procurement is characterized by private or by common values an increase in the potential number of bidders may lead to higher procurement costs. This raises potential policy questions of whether and how entry should be encouraged in public procurement auctions.

We use evidence from auctions of construction contracts to estimate the effect of an increase in the pool of potential bidders on entry and auction prices when entry and bidding decisions are made sequentially with no knowledge of the number or identity of the actual competitors.

Procurement Auctions, Private Values, Common Values, Endogenous Entry

Abstract:
We analyze the dynamics of a game of sequential bidding in the presence of stochastic scale effects in the form of stochastic economies or diseconomies of scale. We show that economies give rise to declining expected equilibrium prices, whereas the converse is not generally true. Moreover, first- and second-price auctions are not always revenue equivalent. Indeed, economies of scale make the second-price format more profitable for the seller, whereas revenue equivalence is preserved in the case of diseconomies.

Abstract:
Since Akerlof's (1970) seminal paper the existence of adverse selection due to asymmetric information about quality is well-understood. Given the negative implications for trading and welfare, the question arises of how such markets come into existence. We consider a market in which firms make observable investment/entry decisions that generate products of a quality that becomes known only to the firm. Entry has the tendency to lower prices, which may lead to adverse selection. The implied price collapse limits the amount of entry so that high prices are supported in the market equilibrium, which results in above normal profits.

While contributing to our understanding of markets with asymmetric information and adverse selection, the model may also provide insight into the question of why markets with adverse selection are empirically hard to identify. The analysis suggests that rather than observing the canonical market collapse, such markets are instead characterized by less entry than would be empirically predicted and above normal profits even in markets with low measures of concentration.

adverse selection, asymmetric information, entry, entry barriers, investment

Abstract:
We study the relationship between financial contracting and entry deterrence when the potential entrant observes the market price but does not observe the financial contract. This leads to the possibility that the entrant and the lender have different beliefs about the incumbent's costs, due to uncertainty in the demand for the good. We show that as a result, the incumbent produces a different level of output in the first period and the probability of entry increases compared to the case when the entrant observes the financial contract.

Experimentation, Strategic Experimentation, Signal Dampening, Signal Jamming, Financial Intermediation, Entry Deterrence

Abstract:
The decision to request a preliminary injunction - a court order that bans a party from certain behavior until its lawfulness is ascertained in a final court ruling at trial - is an important litigation instrument in many areas of the law including antitrust, copyright, patents, trademarks, employment and labor relations as well as contracts. The process of filing for a preliminary injunction and the court's ruling on such a request generates information that can affect possible settlement decisions. We consider these implications when there is uncertainty about both the plaintiff's damages as well as the merits of case in the eyes of the court. Both plaintiff and defendant revise their beliefs about the case strength in dispute once they observe the court's ruling on preliminary injunctive relief. We study how such learning affects the likelihood of settlement. A precursor to this analysis is the study of the strategic role of preliminary injunctions as a means to signal the plaintiff's willingness to settle.

preliminary injunction, learning, signaling, screening, litigation, settlement

Abstract:
The relationship between banks' capitalizations and risk-taking behaviors has been one of the central issues in the banking literature because of its implications on regulatory policies. Despite the fact that a considerable amount of studies have been conducted concerning the issue, neither empirical nor theoretical studies reach a consensus. The aim of this paper is to provide an empirical study on this issue on the basis of new hypotheses and methodologies not utilized in previous studies. We build a testing model that incorporates the different incentives of the three entities that affect the risk determination of a bank; namely regulatory agencies, shareholders, and management. The test results using data from the Korean banking system show apparent differences in risk-capitalization relationships across banks differentiated by the level of capitalization, and across publicly and non-publicly-traded banks. These results provide clear evidence that the risk-capitalization relationships are, indeed, sensitive to the relative forces of the three sources of influence in determining asset risk.

Banks' Risk, Bank Capitalization, Bank Regulation

Abstract:
We study a dynamic coordination game with incomplete information in which players may either be active or inactive. All players initially possess the same information and begin by coordinating on a high level of activity. As the game progresses, agents have different experiences and update accordingly. At some point, agents with a sufficiently long string of bad experiences will decide that the game isn't worth playing and will become inactive. This prospect can cause a total spontaneous collapse of activity in the population at large through a phenomenon we call an information avalanche.

By definition, when an information avalanche occurs, it is part of a Pareto efficient equilibrium and, therefore, does not rely on sun spots or other exogenous coordinating mechanisms. We show that an information avalanche can occur at any point in the game, that its occurrence does not depend on the true state of nature, and that allowing players to exchange information may merely hasten the onset of an avalanche.

Abstract:
This paper characterizes the payoffs and pricing policies of auction hosting sites when both the bidders' and the sellers' participation is endogenous. Sellers have heterogeneous opportunity costs and make a listing decision depending on the fee and the expected revenue from the sale. On the other side of the market, factors such as interface layout and prior bidding experience result in bidder heterogeneity with respect to participation costs. Bidders participate if their ex ante expected payoff from searching the site exceeds their participation costs. The auction site earns revenue by setting positive listing fees, trading off the increased revenue per seller resulting from a higher fee with the revenue reduction from the loss of sellers. Though this appears to be a classic monopoly problem, there are important differences. The reduction in the number of sellers participating in a site has feedback effects, as it affects the number of bidders who would choose to visit that site, which in turn again affects the attractiveness of the site for seller, and thus further reduces seller participation. In this environment, the monopolist's ability to extract rents is severely limited, even if one considers rent extraction from the seller side of the market only. It is demonstrated that the inverse demand curve is flatter than the demand curve obtained from the (inverse) distribution of seller costs. Moreover, the inverse demand curve has at least one and possibly multiple flat segments, leading to discontinuities in the profit function. Thus, small changes in the environment can lead to large changes in the optimal fee and market participation.

Platforms, Intermediaries, Networks, Bidding, Internet markets, Auctions

Abstract:
We contrast a standard deterministic signaling game with a variant where the signal-generating mechanism is subject to stochastic perturbations. In the theoretical part, we obtain a unique equilibrium with stochastic signals. This equilibrium is separating and has intuitive comparative-static properties in that the degree of signaling is a function of the prior distribution of types. With deterministic signals, both pooling and separating configurations occur. We report laboratory data which support the theory remarkably well. In the stochastic variant, there is more signalling behavior than with deterministic signals, and less frequent types distort their signals relatively more. Moreover, the degree of congruence between equilibrium and subject behavior is greater in stochastic settings compared to the deterministic variant.

experiments, noise, signalling, learning, stochastic environments

Abstract:
In the debate over increasing obesity rates, fingers are often pointed at big food and their marketing practices. It is noted that restaurant meals are often larger than home-cooked meals and that portion sizes in restaurants have dramatically increased over the past few years. We investigate the issue by considering socially optimal - rather than decentralized profit maximizing - portions in restaurants to see whether welfare maximizing strategies may also be waistline-increasing. We demonstrate that socially optimal restaurant meals are larger in size than average home-cooked meals and, while many agents chose to super-size, the option of super-sizing actually alleviates the size discrepancy between home-cooked and restaurant meals. Moreover, socially optimal portion sizes at home and in restaurants increase with relative reductions in the marginal costs and/or relative increases in the fixed costs of meal preparation. Given this cost structure, when offered fries, a greater proportion of the population will answer with an enthusiastic yes!

Obesity, Overweightness, Economics of Obesity, Fast Food, Big Food, Consumption Choices

Abstract:
We study the behavior of experimental subjects who have to make a sequence of risky investment decisions in the presence of network externalities. Subjects follow a simple heuristic investing after positive experiences and reducing their propensity to invest after a failure. This result contrasts with the theoretical findings of Jeitschko and Taylor (2001) in which even agents who have only good experiences eventually stop investing because they are afraid that others with worse experiences will quit. In theory, this "Bayesian fear" can trigger sudden economic collapse even in the most efficient Bayesian equilibrium. In the experiment, subjects are surprisingly fearless of others' experiences, and simply follow their own experiences, thus averting a total collapse.

Coordination, Coordination Avalanche, Economic Collapse, Experimental Economics, Network Externalities

Abstract:
Supply relationships and e-auctions are complementary procurement forms that specialty coffee roasters can utilize when designing a procurement strategy. We model the roasters’ optimal choices of procurement strategies using an extended newsvendor model. By comparing the optimal strategies in a benchmark case solely based on relationships to a case in which auctions can be utilized, we derive the impact of e-auctions on the procurement quantity and profit under conditions of demand uncertainty. The two stage model predicts that the adjustment of procurement using e-auctions is most beneficial under market circumstances of high demand variability and small firm size. We use industry data to illustrate the market conditions for specialty coffee and discuss the potential impact of e-auctions on procurement strategies for specialty coffee based on our model. The theoretical propositions in conjunction with current industry data suggest that e-auctions have great potential to become an integral part of and shape roasters’ procurement approaches in the specialty coffee market.

Procurement, E-Auctions, Differentiated Supply Chains, Specialty Coffees, Newsvendor Model

Abstract:
In a model of rational agent choice, in which agents value consumption and leisure as well as health, we establish that individuals, unconstrained by concerns of income or time, can and will choose levels of consumption and leisure that exceed their physiological optima. By how much they exceed the optima depends on a variety of factors, most importantly, the utility cost (benefit) of achieving health. Observed positive trends in adult weight, brought on by higher levels of consumption and lower levels of physical activity, often interpreted as a public health crisis in the making, can be explained by these factors. But, rather than the trend suggesting crisis, it suggests only optimal responses to altered, and perhaps improved, circumstances. While individuals today, all else equal, may weigh more than those a generation or two ago, they are also happier.

Obesity, Overweightness, Economics of Obesity, Consumption Choices, Budget Allocation, Leisure Choices, Time Allocation, Economic Development, Technological Change

Abstract:
We consider auction games where, prior to the auction, bidders spend resources to increase their valuations. The market game is solved by solving an equivalent auxiliary social choice problem. We show that standard auctions are fully efficient, whereas reserve price requirements entail a double inefficiency. Moreover, we explain how optimal auctions differ from the well-known static optimum, and sketch the impact of information spillovers.

Abstract:
The impact of information dissemination and experimentation on
dynamic adverse selection in noisy agency relationships is examined. Significant deviations in terms of equilibrium actions and payments occur, when compared to deterministic environments. Information dissipates slowly, so payments to agents who stand to lose informational rents over time are lower than compared to
deterministic settings. Moreover, the principal manipulates the agent's actions to affect the informativeness of the signal. Thus, the principal trades-off lower initial payments with higher informational rents later. Simultaneously, the principal
manipulates the signal distribution to enhance his ability to learn about the agent's type.

Abstract:
In this paper the impact of noise on dynamic adverse selection in principal-agent relationships is examined. Significant deviations in terms of equilibrium actions and payments occur, when compared to deterministic environments. Information dissipates slowly, so payments to agents who stand to loose informational rents over time are lower than compared to deterministic settings. Moreover, the principal manipulates the agent's actions to affect the informativeness of the signal. Thus, the principal trades-off lower initial payments with higher informational rents later. At the same time, the principal manipulates the signal distribution to enhance the principal's ability to learn about the agent's type.

Abstract:
In many sequential auctions the total number of units to be auctioned is not known at the outset of the auction. However, information regarding the number of units may become available in the course of the auction. The paper examines how such information impacts the formation of prices during the sequence of sales.

Abstract:
In many settings where several objects are auctioned sequentially, the total supply is not known with certainity ex ante. In such settings, price formation over the sequence of sales depends critically on the information available to the bidders regarding the remaining supply. For instance, prices may decline due to a reduced "option value" in early auctions caused by uncertain supply. However, if in the course of the auction it becomes known that fewer than expected units will be auctioned, prices may increase due to diminished supply and the corresponding increase in competition in latter auctions.

Abstract:
In a recurring auction early bids may reveal bidders' types, which in turn affects bidding in later auctions. Bidders take this into account and may bid in a way that conceals their private information until the last auction is played. The present paper analyzes the equilibrium of a sequence of first-price auctions assuming bidders have stable private values. We show that signal-jamming occurs and explore the dynamics of equilibrium prices.

Auctions, Signaling, Price Competition

Abstract:
We study how the threat of entry affects financial contracting between an incumbent firm and a bank, in a stochastic and dynamic environment. Contracts are short term and public. We determine the effects of the first period financial contract on the first period outputs in face of the threat of entry. Specifically, it is shown that the distance between first period outputs is increased due to potential entry. This is due to two underlying effects: first, the threat of entry reduces the signal dampening effect and thus the surplus left to the low cost incumbent is reduced. Second, learning is more valuable as it decreases the probability of entry. Indeed, experimentation takes on a strategic form, since the bank must take into account the impact of the possible game on its expected profits. This work integrates the agency problem between a firm and its financial intermediary with the issue of entry-deterrence under uncertainty.

experimentation, strategic experimentation, signal dampening, financial intermediation, limit pricing, entry deterrence

Abstract:
We study how financial intermediation affects real market variables when an incumbent firm is threatened by entry to its market and must contract with a bank for outside funds. Contracts between the bank and the monopolist are short-term and redesigned after the entry decision of a second firm has been made. We show that---as is often the case in short term contracting without commitment---the first period contract contains signal dampening and experimentation effects. More importantly, however, we show that the threat of entry substantially impacts the significance of both effects. Thus, potential entry reduces the impact of signal dampening. And experimentation takes on a strategic aspect, since it must account for the the potential game between incumbent and entrant should entry occur. As a consequence of this, the first period contract is structured to reduce the probability of entry.

Abstract:
The church has played a central role in establishing and maintaining, as well as undermining, communities throughout history. We explore mechanisms through which it coordinates individual behaviors to achieve improvements in welfare, and reveal ways in which it can fail, causing communities to founder. In our model, inherently religious individuals may become trapped in a secular equilibrium that is strictly dominated by a religious equilibrium. The church, via its teaching, clergy and ministries, reveals the benefits, both in this world and in the world to come, of coordinated behavior and the costs of uncoordinated behavior to induce community members to take individually and socially beneficial actions. External forces, the state and secular society, and internal forces, doctrinal disputes, inconsistencies, and incoherence, reduce a church’s ability to coordinate. Empirical analysis shows that the model’s core features and findings are largely consistent with recent U.S. data on church attendance and tithing.

Economics of Religion, Spirituality, Community Formation, Coordination Failures

Abstract:
An individual's health can be subdivided into three categories: physical health, mental health, and psychic health. Extensive empirical work has shown that the health of the spirit, that is, psychic health, is an important correlate of the health of the body and the mind. To trace the linkages between one's choices concerning the disposition of one's income and time and one's health and well-being broadly defined, we develop a model which allows us to compare individuals with differing spirituality characteristics. While subjective well-being is increasing in one's spirituality, the more spiritual may not be healthier than their less spiritual peers. Those whose faith provides a superior ability to cope with stress and illness, via spiritual capital or a sense of coherence, will have both higher levels of health and subjective well-being. But, these positive health effects are not directly amenable to exploitation by public policy - faith, although nurtured by the Church, cannot be mandated by the State.

Spirituality, spiritual capital, sense of coherence, health and well-being

Abstract:
We develop a theoretical framework where the chance of any given democratic society maintaining its democratic status is determined by two key factors: economic security and the value of freedom in the society. The value of freedom is comprised of freedoms individuals are formally entitled to in the current democratic regime (nominal freedom) and the actual freedoms individual exercise and enjoy (effective freedom), where the latter is determined by the cumulative history of previous experience with democracy. Economic security includes not only current economic performance, but also expectations of future economic performance under democratic and non-democratic regimes, a feature heretofore not included in either the theoretical or empirical work on democracy consolidation or breakdown. The model predicts that democracy survival is more likely the greater the level of effective freedom, the greater the anticipated growth in democracy, the smaller the anticipated growth after democracy breakdown, and finally, the greater the difference between anticipated growth in continued democracy and after democracy breakdown. Data on episodes of democracy that occurred between 1891 and 2006 are used to test the implications of the model. We find that general patterns observed in the data are consistent with our theoretical predictions. Anticipated growth difference has the expected positive effect - if anticipated economic growth under the alternative regime (proxied by current GDP growth in 'peer' countries) is greater than the expected economic growth under democracy (proxied by the country's current GDP growth), then the probability of breakdown is higher. Moreover, an increase in the value of freedom decreases the probability of democracy breakdown. Indeed, the overall level of freedom in neighboring and other countries appears to have a more important impact on democracy survival than a country's own experience. Finally, we find that democracy breakdown is significantly more likely to occur in the first few years, and then the likelihood declines over time.

democracy breakdown, expectations, economic security, freedom

Abstract:
Humans are social creatures that interact in a number of different and at least partially independent social settings, such as work, home, social and political organizations, and church. In each setting one has an identity, or set of identities, which one is called upon to achieve. To obtain and maintain an identity one must dedicate scarce resources. The benefits of expending these resources may be, among other things, income, wealth, success, prestige, power, security, respect, social acceptance, spiritual fulfillment, and salvation. To better understand how the individual makes his resource allocation decisions given the many possible interactions, both positive and negative, across his identities, changes in collective beliefs defining identity, and the substitutability or complementarity of identities, we develop a simple behavioral model of an individual whose personal identity is an amalgam of two identities. We interpret the model in the context of an individual with a secular and a religious identity.

Identity, Collective Beliefs

Abstract:
This is the working paper version of my paper by the same title published in the Southern Economic Journal, 65(1), July 1998, 98-112.

The importance of information is studied in a model of a sequential auction in which bidders have independent private values. In the course of the auction information about the bidders’ values becomes available, as winning bids are revealed. From this bidders learn about their opponents’ types. A more subtle effect of information is that bidders anticipate the generation of information and take this into account in the first auction.

The equilibrium in this model is contrasted to a scenario in which bidders are unaware of informational effects. It is shown that bidders who are aware of informational effects have higher payoffs. However, a static auction, in which informational effects are absent, yields the same expected final allocation as the equilibrium. Finally, properties of the equilibrium price path are studied. Regardless of the outcome of the first auction, the second price is expected to be equal to the first price. Despite this, the probability of a decreasing price sequence depends on the information generated in the first auction.

Sequential Auctions, Learning

Abstract:
The importance of information transmission and learning is studied in a model of a sequential auction in which bidders have independent private values. In the course of the auction information about the bidders' values becomes available, as winning bids are revealed. From this bidders learn about their opponents' types. A more subtle effect of information is that bidders anticipate the generation of information and take this into account in the first auction. The equilibrium in this model is contrasted to a scenario in which bidders are unaware of informational effects. It is shown that bidders who are aware of informational effects place lower bids on average and hence have higher payoffs. Properties of the equilibrium price path are studied. Regardless of the outcome of the first auction, the second price is expected to be equal to the first price. Despite this, the probability of a decreasing price sequence depends on the information generated in the first auction. Finally, it is shown that a simultaneous auction, in which informational effects are absent, yields the same expected final allocation as the equilibrium.

Sequential Auctions, Bayesian Learning, Multi-Unit Auctions

Abstract:
Given increasing obesity rates, fingers are often pointed at "big food" and their marketing practices. Restaurant meals are indeed larger than home-cooked meals, and portion sizes have increased. We consider constrained "socially optimal"-rather than decentralized profit-maximizing-portions to see whether welfare maximizing strategies may also be waistline-increasing. We demonstrate that socially optimal restaurant meals are larger than average home-cooked meals, yet the choice to "super-size" alleviates the size discrepancy. Moreover, portion sizes at home and in restaurants increase with relative reductions in the marginal costs and/or relative increases in the fixed costs of meal preparation. (JEL I10, D11)

Abstract:
The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return. Finally, empirical studies on this issue provide only mixed evidence. The aim of this paper is to shed new light on this issue by expanding existing models to account for the shortcomings identified. Thus, it explicitly models three different incentives of the agents that shape the risk-taking behavior in banking, regulatory bodies, shareholders, and management. The paper considers how the respective incentives influence the riskiness of a bank portfolio for four distinct assumptions about the characteristics of risk-return profiles. As a result it is demonstrated that a bank's risk can either decrease or increase with capitalization. The paper empirically demonstrates the differences in risk-capitalization relationships across high and low capital banks and across publicly and non-publicly traded banks, indicating that risk-capitalization relationships are, indeed, sensitive to the relative forces of the three agents in determining asset risk.

Abstract:
The dynamics of a stochastic, two-period principal-agent relationship is studied. The agent's type remains the same over time. Contracts are short term. The principal designs the second contract, taking the information available about the agent after the first period into account.

Compared to deterministic environments significant changes emerge: First, fully separating contracts are optimal. Second, the principal has two opposing incentives when designing contracts: the principal 'experiments,' making signals more informative; yet dampens signals, thereby reducing up-front payments. As a result, 'good' agents' targets are ratcheted over time.

Bayesian learning, Experimentation, Dynamic agency, Ratchet effect, Regulation, Procurement

Abstract:
In this paper, we analyze the interaction between an incumbent's financial contract with a bank and its product market decisions in the face of a threat of entry, in a dynamic model with asymmetric information. The main results of the paper are: there exists a separating equilibrium with no limit pricing; the low-cost incumbent repays more to the bank in the first period due to the threat of entry; and there are parameter values for which the bank makes more profits with the threat of entry than without.

Entry, Intermediation, Limit pricing, Information