Showing posts with label contracts. Show all posts
Showing posts with label contracts. Show all posts

Tuesday, December 10, 2013

Mechanism design in attorney fees

When it comes to extracting money from clients, you cannot deny that attorneys have learned their Economics. You cannot say the same about the rest of the legal profession, though. So what makes attorneys so smart? Look at how they evaluate which cases to take. It is not about justice for the plaintiff, it is all about what will give them the highest expected return. And the fee schedule can change dramatically according to circumstances.

Take the paper by Winand Emons and Claude Fluet. They observe that defense attorneys use fixed fee contracts while those representing plaintiffs use contingent contracts with a smallish fixed fee. The latter are offered because it provides incentives to pursue strong cases only, they say. Defense attorneys fight all cases, while plaintiff ones can select, and they do it in a way that makes it worth their time. In addition the latter have privileged information: they can figure out the expected winnings, while the plaintiffs are in the dark. The attorneys thus adjust the schedule accordingly. With all this, I wonder whether there is a way to regulate the fees, say by allowing only particular fee structures, that would maximize the well-being of plaintiffs or some combination of plaintiffs, defense and attorneys, not attorneys only.

Monday, October 14, 2013

Building a reputation as online seller

A good reputation is difficult to earn and easy to lose. And reputation matters, think of monetary policy, auditing, medical doctors, restaurants, and politicians. With the Internet, online reviews and reputation have become important as well. I certainly take them into account before buying online. From the point of view of a seller, how do you build a reputations?

Ying Fan, Jiandong Ju and Mo Xiao got access to data to the major Chinese e-commerce platform to study the evolution of seller reputation. In particular, they have been able to trace the strategies and histories on sellers. They show that a good reputation is a great benefit, but that new sellers have a very hard time establishing it. Imagine you start with no reputation whatsoever and are competing with established sellers. To gain an edge, you need to resort to sales and attract attention in various ways, such as cross-listing your product all over the place. This is a lot of effort, and the authors argue that there is too much of it.

This reminds me of the early days of this blog. Being anonymous, I obviously started with no reputation and had to build it from scratch. With barely any readers, I started adding links to unrelated, but interesting stuff to attract more. That did not work, although this has worked for others (restaurant reviews come to mind). It took several years for readership to really pick up, and I thought several times about abandoning during that time.

Friday, June 7, 2013

Why collective wage agreements are bad

Collective bargaining has a few advantages over the alternative, each firm bargaining individually with each trade union. It allows to internalize externalities in the bargaining process. It reduces negotiation costs per firm and union, although it may take longer than for the alternative. However, it prevents individualizing contracts to local circumstances, something that becomes more important as the workforce is getting more human capital and more specialized. Finally, there is that thing with market power.

Xiaomin Cai, Peter Gautier and Makoto Watanabe try to disentangle some of these costs and benefits within a on-the-job search model where both sides are heterogeneous. There is a wage than a planner would use in this context, and it is uniform. However, absent the collective bargaining, you would want wage heterogeneity, because this allows for firms to signal to workers that they have higher labor productivity. Thus, it is better if firms cannot commit to the uniform wage of collective bargaining than if they can commit. A rather unique situation where commitment is bad. And in an empirically plausible case, it is even better not to be restrained by collective bargaining altogether.

Friday, May 24, 2013

Incomplete contracts can be optimal

When you write a contract, you want to lay out what happens in all circumstances. The intuition that this is best comes from the idea that complete markets are ex-ante optimal for everyone. If some circumstances have been left out, then the contract has to be renegotiated, which may lead to issues for example if there is a hold-up problem or worse if lawyer and courts need to get involved. The uncertainty may also lead to insufficient effort by contracting parties. The accepted wisdom is thus that incomplete contracts are bad.

Well, not always. Maija Halonen-Akatwijuka and Oliver Hart argue that one may not want too complete contracts. While there is no denying that it may be costly to draw a complete contract, their argument is that any contingency that is specified may acts as a reference point that may make negotiating for unspecified contingencies more difficult. If I understand this right, complete contracts may still be optimal, but if you have to have an incomplete one, you better not make it too complete. This non-monotonicity stems from the fact that contracted contingencies act as reference points. If there are too many contingencies and a state of the world is realized that is not accounted for, the parties will disagree which contingency should be taken as reference (each party will take the one that suits its interests best). Renegotiation becomes then costly. Have fewer contracted contingencies, and this is less likely to happen.

Wednesday, November 14, 2012

Taking care of free-riders in global warming policies

By now, global warming (or rather global climate change) seems inescapable, with many, many indicators showing a definite trend towards a rapidly changing environment. Given the large scale of this evolution, it is difficult to believe that a simple trick would stop or even reverse it.

David Martimort and Wilfried Sand-Zantman think they found it: get countries to contribute to a general fund and to reduce pollution, but only the most efficient ones at reducing pollution significantly do it. The design of this mechanism is build to solve a double problem: free-riding in participation and effort. The key is to provide a fixed menu of options to countries. This is allows to separate them according to their heterogeneous preferences and abilities, much like insurance companies separate policy holders by offering a menu of policies. In this case, countries would contribute to a green fund more or less, trading this off against subsidies for pollution reduction that are financed from this green fund. The key is that the non-participation of any country would make the whole agreement fail, thus making everyone willing to pay. That is of course under the assumption that no country would actually benefit from climate change. And that it is not too late.

Tuesday, October 9, 2012

Voluntary pollution restrictions do not work

The literature on international environmental agreements has established that when such agreement are only of the self-enforcing kind (not imposed by a supranational entity), they cannot exceed three participants. That is certainly disappointing, as we would need much more than that to get significant impact. This literature, however, looked at these countries in a vacuum, in particular the only interaction they would have is through pollution. Now it turns out that in reality they also trade with each other, and trade policy is also available as an instrument.

This is how Thomas Eichner and Rüdiger Pethig expand the extant literature. The addition of trade allows more countries to participate in a self-enforcing agreement. But this comes at the cost of an agreement with significantly less bite. These are interesting results, but I have a hard time finding intuition for this, and the authors are not of much help. Consider this to be an appeal for clarification.

Friday, June 24, 2011

Property rights and natural resources

It is a firmly established conventional wisdom that natural resources are best preserved when there are well established property rights. It is the quintessential example of the tragedy of the commons that if everyone is allowed, say, to take water, water will be over-exploited. This wisdom takes, however, a crucial assumption: that once the resources is taken, property rights are well established and uncontestable. What would happen if not?

Louis Hotte, Randy McFerrin and Douglas Wills show that reverting this assumption can have a dramatic impact. Suppose that you took a freely available resource, but that now anyone can contest your ownership of that resource. Depending on the consequences, you may not want to extract in the first place. It thus matters in which way the state is weak. If it is weak in that it gives away rights to natural resources, then there will be over-exploitation. If it is weak in that it cannot enforce property rights in general, and in particular when it comes to bring product to the market, then it is the Wild West and under-exploitation may ensue. Theft is a powerful mechanism to kill markets.

Friday, October 22, 2010

Why should marriages be eternal contracts?

Risk sharing contracts are good contracts, and they can have an important welfare benefit. However, it is not quite clear that these contracts should be valid for a life-time. Indeed, this is what marriage is. Aside from the fact that these contracts are restricted to be signed between people of opposite gender, one can also question why not more people could be included in them. That would be good risk diversification. The problem is that a marriage contract is not just about risk sharing (and for that we have a market for insurance contracts nowadays), it is also about limiting sex choices and commitments to supporting children. But all this could be achieved without marriage.

Anyway, Stefania Marcassa and Grégory Ponthière ask whether marriage contracts should be eternal and find that in most cases they should not. Their argument has nothing to do with risk and uncertainty, rather with declining match quality and unequal bargaining power. Indeed, when one potential partner has little bargaining power, marriage gives an important veto power. But when bargaining powers are rather equal, like they are nowadays, long-term contracts become more interesting because no one has an incentive to veto a marriage due to unequal power.

Tuesday, September 7, 2010

The iPhone must have an exclusive carrier

Aren't you angry that the particular mobile phone you prefer has an exclusive contract with a carrier? This limitation of carrier choice seems anti-competitive, if not frustrating. US anti-trust authorities seem to be getting interested in these arrangements and may intervene. It turns out that maybe they should not.

Robert Hahn and Hal Singer say exclusivity contracts are in fact the best thing that could happen for consumer welfare. Indeed, they spur competition through innovation, and the fact that the smart phone industry is innovative is hardly an understatement. Indeed, the exclusive contracts allow manufacturers to share the risk with the carrier, they make sure that both want the success of the new phone, and thus insure better reception and coverage. All this taken together induces manufacturers to take more risk and go for even faster and bolder innovations, which ultimately benefits the consumer.

Tuesday, June 8, 2010

An economic model of God

To publish in Economics, marketing your paper is unfortunately very important. And it all starts with a catchy title. Some subjects can inspire you to absolutely great titles, like this one: "An Economist's Guide to Heaven." Dan Hamermesh could have penned that, but it is a paper by Nick Muller, Jo Anna Gray and Joe Stone.

The paper is not about how you can make sure the Pearly Gates are open to you, but rather it "offers an economic model of God and humanity as optimizing agents in the context of concrete belief archetypes (religious ‘contracts’) in Judeo-Christian theology." In plainer words, they study how belief about God influences the behavior of optimizing agents. In this paper, God optimizes, too, and believers know that. People care about private consumption, public goods and what God does to them, if they are believers. God benevolent, as He cares about public goods and likes to reward people instead of punishing them. Believers have a contract with God that entices them to provide public goods in exchange of godly rewards or punishments. Contracts can take four different forms, depending on the archetype within the Judeo-Christian belief system, which lead to different outcomes that can be tested using the General Social Science Survey.

Results are consistent with the model: strength of faith is irrelevant if there is no penalty in the contract, believers renege if there is no penalty, and contracts with penalty work, even if penalties are never exercised. What remains to be understood, though, is why there are believers in the first place.

Thursday, February 25, 2010

Why boards keep bad CEOs

As described in a previous blog post, CEOs are not as expensive to a firm as commonly perceived, and they are are real bargain. Still, you have sometimes to wonder why some CEOs stay in charge despite lackluster performance. Is the board asleep at the wheel? The conventional wisdom is that it is all an inside job. As the CEO selects the board and the board selects the CEO, they all protect each other. And when a CEO really needs to be replaced, he is chosen among the members of the board.

Meg Sato advances that there could be another reason. It is all about rent seeking. The board may have interests that differ from shareholders, and thus wants to appoint or keep a CEO who performs in its eyes, but not in the eyes of shareholders. This happens because the CEO is kind to the board and will minimize the leakage of the surplus of the board.

The way this is analyzed is by model this as a Nash game, where CEO wage, costly CEO monitoring and CEO succession policy (internal vs. external) are determined. Because the board does not internalize the welfare of an outsider CEO candidate, it will tend to prefer an insider and monitor him little. Because CEO skills are perfectly observable ex-ante, such skills matter more in heterogeneous industries, and incumbents or insiders have acquired firm-specific knowledge, heterogeneous industries should have more insider CEOS and and longer CEO tenures. While this paper is purely theoretical, other empirical work confirms this conjecture.

Tuesday, February 16, 2010

Should we own our children?

We sink a lot of resources into our children, be it in time or money. while they are children, the return is largely non-material. Thereafter, there can be a material return, directly if children support their parents during old age (and often the support still goes the other way), or indirectly if there is a pay-as-you-go social security system. Given this lack if private return in children, and that it is lower than the social return, there is underinvestment in children, in quantity and quality. This can be corrected with subsidized schooling and fertility incentives.

Alice Schoonbroodt and Michèle Tertilt make the argument that all this could easily be resolved by giving parents the full rights on the income of their offspring. Then they would get the full return of their investment and have socially optimal fertility and investment. Of course, this is not possible, first because of human rights, and second because children cannot be committed to give up their income. But there was a time where parents could exert such control, and then fertility was also higher. In other word, altruism is not the only reason for fertility.

This brings another interesting aspect on the paper. Under normal circumstances, the Coase Theorem would apply, but here it cannot as parents cannot contract with unborn children, and the latter cannot make promises to their parents. This inefficiency can only be resolved with public intervention, either by by giving property rights to parents, or by giving parents appropriate incentives, financed by taxing children. The fact that fertility is endogenous, contrarily to what is typically assumed, has another consquence: the standard results that allocations are efficient if the interest rate is higher than the population growth rate is not necessarily valid, because of under-fertility in addition to the usual problem of over-saving. In other word, endogenous fertility is very important, and all these social security models that just assume fertility is reduced are missing something big.

Thursday, September 24, 2009

On the advantage of marriage over cohabitation

Why marry when cohabitation can provide the same benefits of economies of scale and companionship? One may even think that cohabitation is superior because it allows a break up with less consequences. That is exactly wrong. The fact that divorce is costly makes that one is more careful in committing to marriage and, once married, one puts more effort into the marriage. The key here is that marriage is a commitment device that gives strong incentives to make a marriage work.

Murat Iyigun shows that this logic gives marriage a large surplus than cohabitation through spousal commitment, as long as men and women are available in roughly equal numbers and commitment costs are symmetric across genders. Otherwise, marriage surpluses collapse and cohabitation dominates.

The fact is that commitment costs are not equal, mostly because of children and traditional roles in the household and the labor market. In fact, the countries where women are the most equal to men (say, Scandinavia) are those where cohabitation is the most prevalent. That evidence goes exactly counter to the predictions of the Iyigun model. Unfortunately, the paper provides absolutely no empirical support for its results. In fact, it is not even motivated by any empirical fact that would need to be explained. What is it then good for?

Thursday, May 14, 2009

How to best auction natural resources

It is now well known that many natural resources suffer from the tragedy of the commons: because they are not owned, they are overused and depleted. The solution is for the state to sell rights to them. Those rights were typically set administratively and often with political considerations, thinks of the ultra-low grazing rights on federal lands. But governments can obtain more for the natural resources, not only because it increases revenue, but also because it encourages an efficient use of scarce resources. After all, the market price is still a wonderful signal. Thus auctions come into play. But auctions can go horribly wrong as well, as documented by Paul Klemperer. Every auction is different, and details are important.

Peter Cramton offers a handy guide for the design of efficient natural resource auctions. It focuses on oil and mineral rights in developing economies, but there are lessons to be learned for other auctions as well. There is an incredible array of auction designs, which helps accommodate a multitude of market situations and government goals. So, the next time you have an oil field to sell, you know where to look!

Tuesday, September 30, 2008

What is a CEO worth?

Now that Congress seems due to pass this horrible bailout bill, let us reflect a little on one provision that seems to have sweetened the deal: limits to executive compensation. CEO pay has been controversial for a while now, so it is natural to ask whether they are worth it.

This is what Marko Terviö does using an assignment model and data from 1000 publicly traded US firms. First about the assignment model: its idea is to match firms and CEOs with different characteristics. Outcomes depend on the distribution of those characteristics, and as they are in fixed supply, the price of ability does not necessarily reflect marginal productivity.

The market value of a firm is pivotal here, as it is not only dependent on its current characteristics (and CEO), but future ones as well. Also, a firm contains capital that can be transferred to others. The current surplus of a firm is the product of CEO ability, firm size, a growth factor and capital. This may seem oversimplifying, but you needs to keep managerial ability observable by deduction.

Matching this model with Compustat data, the top 1000 CEOs appear to contribute between US$21 and 25 billion in 2004 (about 0.15% of market capitalization), and they have been paid $7.1 billion for it, including option packages. CEOs seem to be of little impact, but still a bargain. But what if all CEOs were replaced with the best one? The surplus gain would be $3.2-3.4 billion, rather modest. The reason is that the best are already matched with the largest firms.

Friday, July 18, 2008

On-the-job search and exploding wages

Real wages have been largely stagnant over the last decades for most workers, except for huge increases for some specialists, like CEOs, athletes and even some academics. Why so? Giuseppe Moscarini offers an explanation: it is all about the corporate culture and how employers chose to match outside offers for their employees or not.

Back in the 1970s, say, it was accepted by all human resource managers that outside offers should not be matched. Knowing this, employees had little incentive to pursue on-the-job searches. If they obtained an offer, the monetary, time and psychological cost of moving jobs (and potentially living quarters) made an outside offer little attractive. As a consequence, wages followed closely productivity.

Suppose now that the employer cannot commit to not match outside offers. Employees will then seek more outside offers, thus generating wage increases through matching. Knowing this, workers are willing to accept lower initial wages, expecting future increases. Wages now are disconnected from productivity.

Note that an employer who has matched an outside offer in the past cannot credibly commit not to match in the future, as its employees are actively seeking outside jobs. Thus matching once leads to an irreversible change in equilibrium.

It remains that for most professions, matching of outside offers in unheard of. But once it happens, expect a sudden boost in wages. Expect no increases thereafter, as firms have exhausted themselves trying to outbid each other.

Friday, July 11, 2008

On the pitfalls of institutional reform in developing economies

What is Africa's problem. Many argue it is an issue of governance. One needs proper ownership rights, in particular for land, for an economy to function efficiently and to encourage entrepreneurship. For this reason, international organization, foreign governments and some NGOs insist on a regular basis on governance reform. This is not necessarily a good idea.

William Easterly and Dani Rodrik have for quite a while highlighted that such western style reforms may be ill-suited for developing economies. The main point is that these reforms are not performed in a vacuum. For example, there is typically already a system of ownership in place. It may not use the same institutions as in a Western economy, but it somehow works. Or business contracts are honored through "informal ways", like reputation.

In the latter case, imposing a system with formal courts may backfire: as they enforcement capability may not be high, people may want to opt out of contracts they would have kept in a reputation system. In this sense, the existing system may be a second best institution that would have to be reformed from the bottom up.

Thursday, December 27, 2007

How to stick to your New Year's resolutions

Soon is the time to make resolutions, and like most resolutions, they will fall to the wayside within days or at best weeks. Now, how could Economics help you?

StickK.com is run by a group of faculty at Yale University following on a very simple principle: if nothing tangible is at stake, there is little incentive to stick to a resolution. However, if you have committed to some amount of money, then the thread of losing that amount will make you stick. Thus, at StickK.com, you set a price and a deadline for a goal, typically losing weight. If you succeed, and independent auditor verifies your claim and you are home free and happy. If not, you have to pay in your collateral, which will then be forwarded to a charity. If you are wondering, the website hopes to make money from ads, in particular for weight loss (surprise...).

Will this work? It is clear that once money is at stake, anybody is more careful. Just think about all the liability threats and how they restrict actual behavior. There are, however, a few issues with the case at hand:
  1. How can such a contract be enforced? This looks like a big hassle StickK.com will face once it has to collect money from people who cannot commit. If they cannot commit to losing weight, aren't they also likely not be able to commit to paying?
  2. Would courts accept this as a valid contract? Indeed, it seems to be quite one-sided. I am no lawyer, but it looks like StickK.com is not providing a service when it asks for payment, as the person has not lost weight...
  3. It is not clear how the auditing could be performed at low cost.
  4. A payment to charity may not be a sufficient incentive to stick to a resolution. A much better deterrent would be a payment to, say, your mother-in-law, the Mafia or your local property owners association. This would, by the way, also take care of the auditing.
At least this is a start. Let's see how it works out. But, at the time of this writing, the scheme is not yet functional and the busiest time for resolutions is approaching fast. I wonder how the founders have committed to that deadline.