Flexible Contracts

48 Pages Posted: 1 Feb 2010

See all articles by Piero Gottardi

Piero Gottardi

European University Institute - Department of Economics; Ca Foscari University of Venice - Dipartimento di Economia; CESifo (Center for Economic Studies and Ifo Institute)

Jean-Marc Tallon

Paris School of Economics

Paolo Ghirardato

Collegio Carlo Alberto

Date Written: January 2010

Abstract

This paper studies the costs and benefits of delegating decisions to superiorly informed agents relative to the use of rigid, non discretionary contracts. Delegation grants some flexibility in the choice of the action by the agent, but also requires the use of an appropriate incentive contract so as to realign his interests with those of the principal. The parties' understanding of the possible circumstances in which actions will have to be chosen and their attitude towards risk and uncertainty play then an important role in determining the costs of delegation. The main focus of the paper lies indeed in the analysis of these costs and the consequences for whether or not delegation is optimal.

We determine and characterize the properties of the optimal flexible contract both when the parties have sharp probabilistic beliefs over the possible events in which the agent will have to act and when they only have a set of such beliefs. We show that the higher the agent's degree of risk aversion, the higher the agency costs for delegation and hence the less profitable is a flexible contract versus a rigid one. The agent's imprecision aversion in the case of multiple priors introduces another, additional agency costs; it again implies that the higher the degree of imprecision aversion the less profitable flexible contracts versus rigid ones. Even though, with multiple priors, the contract may be designed in such a way that principal and agent end up using 'different beliefs' and hence engage in speculative trade, this is never optimal, in contrast with the case where the parties have sharp heterogeneous beliefs.

Keywords: delegation, flexibility, agency costs, multiple priors, imprecision aversion

JEL Classification: D86, D82, D81

Suggested Citation

Gottardi, Piero and Tallon, Jean-Marc and Ghirardato, Paolo, Flexible Contracts (January 2010). Available at SSRN: https://ssrn.com/abstract=1545727 or http://dx.doi.org/10.2139/ssrn.1545727

Piero Gottardi (Contact Author)

European University Institute - Department of Economics ( email )

Villa Schifanoia
133 via Bocaccio
Firenze (Florence), Tuscany 50014
Italy

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy
+39 041 257 4192 (Phone)
+39 041 257 4176 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Jean-Marc Tallon

Paris School of Economics ( email )

Paolo Ghirardato

Collegio Carlo Alberto ( email )

via Real Collegio 30
Moncalieri, Torino 10024
Italy
+390116705220 (Phone)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
90
Abstract Views
781
rank
357,375
PlumX Metrics