Endogenous Contractual Externalities

44 Pages Posted: 25 Sep 2014

See all articles by Emre Ozdenoren

Emre Ozdenoren

London Business School; Centre for Economic Policy Research (CEPR)

Kathy Yuan

London School of Economics & Political Science (LSE) - Department of Finance

Date Written: July 2014

Abstract

We study ffort 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 internalize 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: boom-bust effort exertion, contractual externalities, relative and absolute performance contracts, risk taking

JEL Classification: D86, G01, G30

Suggested Citation

Ozdenoren, Emre and Yuan, Kathy Zhichao, Endogenous Contractual Externalities (July 2014). CEPR Discussion Paper No. DP10052, Available at SSRN: https://ssrn.com/abstract=2501525

Emre Ozdenoren (Contact Author)

London Business School ( email )

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Centre for Economic Policy Research (CEPR)

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United Kingdom

Kathy Zhichao Yuan

London School of Economics & Political Science (LSE) - Department of Finance ( email )

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London, London WC2A 2AE
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HOME PAGE: http://fmg.lse.ac.uk/~kathy

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