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Abstract:
We model a run on a financial market, in which each risk-neutral investor fears having to liquidate shares after a run, but before prices can recover back to fundamental values. To avoid having to possibly liquidate shares at the marginal post-run price - in which case the risk-averse market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares - each investor may prefer selling today at the average in-run price, thereby causing the run itself. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.

Abstract:
This paper explains why seemingly irrational overconfident behavior can persist. Information aggregation is poor in groups in which most individuals herd. By ignoring the herd, the actions of overconfident individuals ("entrepreneurs") convey their private information. However, entrepreneurs make mistakes and thus die more frequently. The socially optimal proportion of entrepreneurs trades off the positive information externality against high attrition rates of entrepreneurs, and depends on the size of the group, on the degree of overconfidence, and on the accuracy of individuals' private information. The stationary distribution trades off the fitness of the group against the fitness of overconfident individuals.

Evolution, Overconfidence, Behavioral Economics

Abstract:
We consider optimal capital allocation and managerial compensation mechanisms for decentralized firms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always under invest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the under investment problem and the composition of managerial compensation contracts. We also find that firms will optimally give greater performance-based pay (at the expense of fixed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Thus, managers may receive greater performance-based pay because they manage higher-quality projects, not that greater performance-based pay causes firm value to increase.

Abstract:
This article analyzes how legal presumptions can mediate between costly litigation and ex ante incentives. We augment a moral hazard model with a redistributional litigation game in which a presumption parameterizes how a court 'weighs' evidence offered by the opposing sides. Strong prodefendant presumptions foreclose lawsuits altogether, but also engender shirking. Strong proplaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which both shirking and suit occur probabilisitically. The socially optimal presumption trades off agency costs against litigation costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of our model: the litigation rate effects of the 1995 Private Securities Litigation Reform Act, the business judgment rule in corporations law, and fiduciary duties in financially distressed firms.

Abstract:
This paper develops a theoretical account of presumptions, focusing on their capacity to mediate between costly litigation and ex ante incentives. We augment a standard moral hazard model with a redistributional litigation game in which a legal presumption parameterizes how a court "weighs" evidence offered by the opposing sides. Strong pro-defendant presumptions can foreclose lawsuits altogether, but also lead to shirking. Strong pro-plaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which productive effort and suit occur probabilistically. The socially-optimal presumption trades off litigation costs against agency costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of the model: the business judgment rule in corporations law, fiduciary duties in financially-distressed firms, and the doctrine of res ipsa loquitur in accident law.

Abstract:
This note extends the Bernardo, Talley & Welch (1999) model of legal presumptions to study situations where litigation efforts are spent sequentially rather than simultaneously. The equilibria of the litigation stage are presented as functions of the underlying presumption. The equilibria and comparative statics are shown to be qualitatively similar to those of the simultaneous version. However, sequentiality allows the principal to pre commit to a litigation strategy, and thus possibly preempt any litigation effort whatsoever by the agent.

Abstract:
We consider the problem of motivating privately informed managers to engage in entrepreneurial activity to improve the quality of the firm's investment opportunities. The firm's investment and compensation policy must balance the manager's incentives to provide entrepreneurial effort and to report her private information truthfully. The optimal policy is to underinvest (compared to first-best) and provide weak incentive pay in low-quality projects and overinvest (compared to first-best) and provide strong incentive pay in high-quality projects. We also show that, unlike the standard agency model, uncertainty and incentives can be positively related.

Abstract:
Our paper studies an economy in which each financial institution takes into account that if it has to sell its assets after others have already sold, the price will be lower. This causes preemptive selling, driven not by actual margin calls, but by the fear of future margin calls. Financial institutions cannot determine their optimal capitalizations in isolation, but need to know the aggregate capitalization. The resulting equilibrium is fragile: Small changes in model parameters can cause large changes in the equilibrium allocation of risk. Our model is a natural complement to Allen and Gale (2004).

Leverage, Banks, Financial Institutions, Preemptive Selling, Fire Sales

Abstract:
Our paper offers a minimalist model of a run on a financial market. The prime ingredient is that each risk-neutral investor fears having to liquidate after a run, but before prices can recover back to fundamental values. During the urn, only the risk-averse market-making sector is willing to absorb shares. To avoid having to possibly liquidate shares at the marginal post-run price in which case the market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares all investors may prefer selling their shares into the market today at the average run price, thereby causing the run itself. Consequently, stock prices are low and risk is allocated inefficiently. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.

Abstract:
Considering that roughly 75 percent of new businesses fail within the first five years, it is difficult to account for entrepreneurs' irrationally overconfident behavior.One explanation is that overconfident entrepreneurs are less likely to imitate their peers and more likely to explore their environment.When groups compete and inferior groups disappear, groups with some entrepreneurial activity may gain enough of an evolutionary advantage to permit entrepreneurs to survive in equilibrium; in other words, groups with some overconfident individuals have an evolutionary advantage over groups without such individuals. A model illustrates the idea that overconfidence imposes only small costs on entrepreneurs (who put too much weight on their own information) but provides large benefits in revealing their private information to their groups.The presentation of the model is followed by a discussion of factors influencing the trade-off between the positive information externality and the high rate of entrepreneurial attrition.This trade-off results in an optimal proportion of entrepreneurs and depends on the size of the group, the degree of overconfidence, and the accuracy of individuals' private information. What follows is a discussion of the trade-off between intergroup and intragroup selection, as well as arguments pro and con group selection.One alternative explanation for overconfidence exists: when trying to deceive others that they are of higher ability, individuals' credibility is enhanced if they are themselves convinced of this ability.(SAA)

Theoretical, Overconfidence, Self-efficacy, Management decisions, Startups, Groups, Risk orientation, Survival rates

Abstract:
We examine the problem of motivating privately informed managers to engage in entrepreneurial activity to improve the quality of the firm's investment opportunities. The firm's investment and compensation policy must balance the manager's incentives to provide entrepreneurial effort and to report private information truthfully. The optimal policy is to underinvest (compared to first-best) and provide weak incentive pay in low-quality projects and overinvest (compared to first-best) and provide strong incentive pay in high-quality projects.

D82, D86, G31

Abstract:
We develop an approach to asset pricing in incomplete markets that bridges the gap between the two fundamental approaches in finance: model-based asset pricing and pricing by no arbitrage. We strengthen the absence of arbitrage assumption by precluding investment opportunities whose attractiveness to a benchmark investor exceeds a specified threshold. In our framework, the attractiveness of an investment opportunity is measured by the gain-loss ratio. We show that a restriction on the maximum gain-loss ratio is equivalent to a restriction on the ratio of the maximum to minimum values of the pricing kernel. By limiting the maximum gain-loss ratio, we can restrict the set of admissible pricing kernels, which in turn allows us to restrict the set of prices that can be assigned to assets. We illustrate our methodology by computing price bounds for call options in a Black-Scholes economy without intermediate trading. When we vary the maximum permitted gain-loss ratio, these bounds can range from the exact prices implied by a model-based pricing approach to the loose price bounds implied by the no-arbitrage approach.

Abstract:
This paper offers a novel explanation for why some firms prefer to pay dividends rather than repurchase shares. It is well-known that institutional investors are relatively less taxed than individual investors, and that this induces "dividend clientele" effects. We argue that these clientele effects are the very reason for the presence of dividends, because institutions have a relative advantage in monitoring firms or in detecting firm quality. Firms paying dividends attract relatively more institutions and perform better. The theory is consistent with some documented regularities, such as a reluctance of firms to cut dividends, and offers novel empirical implications, such as a prediction that is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments.