CONTRACT THEORY. Patrick Bolton and Mathias Dewatripont. The MIT Press Cambridge, Massachusetts London, England

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1 r CONTRACT THEORY Patrick Bolton and Mathias Dewatripont The MIT Press Cambridge, Massachusetts London, England

2 Preface xv 1 Introduction Optimal Employment Contracts without Uncertainty, Hidden Information, or Hidden Actions Optimal Contracts under Uncertainty Pure Insurance Optimal Employment Contracts under Uncertainty Information and Incentives Adverse Selection Moral Hazard Optimal Contracting with Multilateral Asymmetric Information Auctions and Trade under Multilateral Private Information Moral Hazard in Teams, Tournaments, and Organizations The Dynamics of Incentive Contracting Dynamic Adverse Selection Dynamic Moral Hazard Incomplete Contracts Ownership and Employment Incomplete Contracts and Implementation Theory Bilateral Contracts and Multilateral Exchange Summing Up 42 Part I STATIC BILATERAL CONTRACTING 45 2 Hidden Information, Screening The Simple Economics of Adverse Selection First-Best Outcome: Perfect Price Discrimination Adverse Selection, Linear Pricing, and Simple Two-Part Tariffs Second-Best Outcome: Optimal Nonlinear Pricing Applications Credit Rationing Optimal Income Taxation 62

3 2.2.3 Implicit Labor Contracts Regulation More Than Two Types Finite Number of Types Random Contracts A Continuum of Types Summary Literature Notes 96 Hidden Information, Signaling Spence's Model of Education as a Signal Refinements Applications Corporate Financing and Investment Decisions under Asymmetric Information Signaling Changes in Cash Flow through Dividend Payments Summary and Literature Notes 125 Hidden Action, Moral Hazard Two Performance Outcomes First-Best versus Second-Best Contracts The Second Best with Bilateral Risk Neutrality and Resource Constraints for the Agent Simple Applications Bilateral Risk Aversion The Value of Information Linear Contracts, Normally Distributed Performance, and Exponential Utility The Suboptimality of Linear Contracts in the Classical Model General Case: The First-Order Approach Characterizing the Second Best When is the First-Order Approach Valid? Grossman and Hart's Approach to the Principal-Agent Problem Applications 157

4 vii Contents Managerial Incentive Schemes The Optimality of Debt Financing under Moral Hazard and Limited Liability Summary Literature Notes 169 Disclosure of Private Certifiable Information Voluntary Disclosure of Verifiable Information Private, Uncertifiable Information Private, Certifiable Information Too Much Disclosure Unraveling and the Full Disclosure Theorem Generalizing the Full Disclosure Theorem Voluntary Nondisclosure and Mandatory-Disclosure Laws Two Examples of No Disclosure or Partial Voluntary Disclosure Incentives for Information Acquisition and the Role of Mandatory-Disclosure Laws No Voluntary Disclosure When the Informed Party Can Be Either a Buyer or a Seller Costly Disclosure and Debt Financing Summary and Literature Notes 197 Multidimensional Incentive Problems Adverse Selection with Multidimensional Types An Example Where Bundling Is Profitable When Is Bundling Optimal? A Local Analysis Optimal Bundling: A Global Analysis in the 2 x 2 Model Global Analysis for the General Model Moral Hazard with Multiple Tasks Multiple Tasks and Effort Substitution Conflicting Tasks and Advocacy An Example Combining Moral Hazard and Adverse Selection Optimal Contract with Moral Hazard Only Optimal Contract with Adverse Selection Only 231

5 6.3.3 Optimal Sales with Both Adverse Selection and Moral Hazard Summary and Literature Notes 233 PartH STATIC MULTILATERAL CONTRACTING Multilateral Asymmetric Information: Bilateral Trading and Auctions Introduction Bilateral Trading The Two-Type Case Continuum of Types Auctions with Perfectly Known Values Optimal Efficient Auctions with Independent Values Optimal Auctions with Independent Values Standard Auctions with Independent Values Optimal Independent-Value Auctions with a Continuum of Types: The Revenue Equivalence Theorem Optimal Auctions with Correlated Values The Role of Risk Aversion The Role of Asymmetrically Distributed Valuations Auctions with Imperfectly Known Common Values The Winner's Curse Standard Auctions with Imperfectly Known Common Values in the 2 x 2 Model Optimal Auctions with Imperfectly Known Common Values Summary Literature Notes Appendix: Breakdown of Revenue Equivalence in a 2 x 3 Example Multiagent Moral Hazard and Collusion Moral Hazard in Teams and Tournaments Unobservable Individual Outputs: The Need for a Budget Breaker 301

6 ix Contents Unobservable Individual Outputs: Using Output Observations to Implement the First Best Observable Individual Outputs Tournaments Cooperation or Competition among Agents Incentives to Help in Multiagent Situations Cooperation and Collusion among Agents Supervision and Collusion Collusion with Hard Information Application: Auditing Hierarchies Summary Literature Notes 362 Part III REPEATED BILATERAL CONTRACTING Dynamic Adverse Selection Dynamic Adverse Selection with Fixed Types Coasian Dynamics Insurance and Renegotiation Soft Budget Constraints Regulation Repeated Adverse Selection: Changing Types Banking and Liquidity Transformation Optimal Contracting with Two Independent Shocks Second-Best Risk Sharing between Infinitely Lived Agents Summary and Literature Notes Dynamic Moral Hazard The Two-Period Problem No Access to Credit Monitored Savings Free Savings and Asymmetric Information The T-period Problem: Simple Contracts and the Gains from Enduring Relations 431

7 Repeated Output Repeated Actions Repeated Actions and Output Infinitely Repeated Actions, Output, and Consumption Moral Hazard and Renegotiation Renegotiation When Effort Is Not Observed by the Principal Renegotiation When Effort Is Observed by the Principal Bilateral Relational Contracts Moral Hazard Adverse Selection Extensions Implicit Incentives and Career Concerns The Single-Task Case The Multitask Case The Trade-Off between Talent Risk and Incentives under Career Concerns Summary Literature Notes 484 Part IV INCOMPLETE CONTRACTS Incomplete Contracts and Institution Design Introduction: Incomplete Contracts and the Employment Relation The Employment Relation A Theory of the Employment Relation Based on Ex Post Opportunism Ownership and the Property-Rights Theory of the Firm A General Framework with Complementary Investments A Framework with Substitutable Investments Financial Structure and Control Wealth Constraints and Contingent Allocations of Control 523

8 Wealth Constraints and Optimal Debt Contracts when Entrepreneurs Can Divert Cash Flow Summary Literature Notes Foundations of Contracting with Unverifiable Information Introduction Nash and Subgame-Perfect Implementation Nash Implementation: Maskin's Theorem Subgame-Perfect Implementation The Holdup Problem Specific Performance Contracts and Renegotiation Design Option Contracts and Contracting at Will Direct Externalities Complexity Ex Post Unverifiable Actions Financial Contracting Formal and Real Authority Ex Post Unverifiable Payoffs The Spot-Contracting Mode The Employment Relation and Efficient Authority Summary and Literature Notes Markets and Contracts (Static) Adverse Selection: Market Breakdown and Existence Problems The Case of a Single Contract The Case of Multiple Contracts Contracts as a Barrier to Entry Competition with Bilateral Nonexclusive Contracts in the Presence of Externalities The Simultaneous Offer Game The Sequential Offer Game The Bidding Game: Common Agency and Menu Auctions Principal-Agent Pairs 630

9 13.5 Competition as an Incentive Scheme Summary and Literature Notes 641 APPENDIX Exercises 647 References 687 Author Index 709 Subject Index 715

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