Optimal Contracting in Networks

89 Pages Posted: 5 May 2016 Last revised: 17 Aug 2018

See all articles by Ali Jadbabaie

Ali Jadbabaie

Institute for Data, Systems, and Society, Massachusetts Institute of Technology

Ali Kakhbod

Massachusetts Institute of Technology (MIT) - Department of Economics

Date Written: April 1, 2016

Abstract

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 one agent’s trade propagates through the network and creates unequal and network-dependent downward distortion in other agents’ trades. We also explicitly describe bilateral contracts (i.e., the non-linear pricing) and characterize their explicit dependence on the network structure. We show that firm will benefit from uncertainty in agents’ valuation of other agent’s externality. We further elucidate 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 unboundedly with the size of networks.

Keywords: Network Economics. Information rent. Asymmetric information. Multilateral contracts. Bilateral contracts

JEL Classification: D82. D86. D42

Suggested Citation

Jadbabaie, Ali and Kakhbod, Ali, Optimal Contracting in Networks (April 1, 2016). MIT Sloan Research Paper No. 5173-16. Available at SSRN: https://ssrn.com/abstract=2774600 or http://dx.doi.org/10.2139/ssrn.2774600

Ali Jadbabaie

Institute for Data, Systems, and Society, Massachusetts Institute of Technology ( email )

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02139, MA MA 02139
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HOME PAGE: http://web.mit.edu/www/jadbabai

Ali Kakhbod (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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