Optimal Contracting in Networks
91 Pages Posted: 5 May 2016 Last revised: 8 Apr 2019
Date Written: April 1, 2016
We study optimal contracting between a firm selling a divisible good that exhibits positive externality and a group of agents in a social network. The extent of externality that each agent receives from the consumption of neighboring agents is privately held and is unknown to the firm. By explicitly characterizing the optimal multilateral contract, we demonstrate how inefficiency in an agent’s trade propagates through the network and creates unequal and network-dependent downward distortion in other agents’ trades. Furthermore, we describe bilateral contracts (i.e., the non-linear pricing scheme) and characterize their explicit dependence on the network structure. We show that the firm will benefit from uncertainty in agents’ valuation of other agents’ externality. Next we describe the profit gap between multilateral and bilateral contracts and analyze the consequences of the explicit dependence of the contracts on network structure. When the network is balanced in terms of homogeneity of agents’ influence, network structure has no impact on the firm’s profit when contracts are bilateral. On the other hand, when the influences are heterogeneous with high dispersion (as in core-periphery networks) the restriction to bilateral contracts can result in profit losses that grow unbounded with the size of networks.
Keywords: Network Economics, Information Rent, Asymmetric Information, Multilateral Contracts, Bilateral Contracts
JEL Classification: D82, D86, D42
Suggested Citation: Suggested Citation