On the Optimal Use of Correlated Information in Contractual Design Under Limited Liability

47 Pages Posted: 8 Jun 2018

See all articles by Daniel Danau

Daniel Danau

Université de Caen Basse-Normandie

Annalisa Vinella

University of Bari - Department of Economics and Finance

Date Written: April 19, 2018

Abstract

Riordan and Sappington (JET, 1988) show that in an agency relationship in which the agent’s type is correlated with a public ex post signal, the principal may attain first best (full surplus extraction and efficient output levels) if the agent is faced with a lottery such that each type is rewarded for one signal realization and punished equally for all the others. Gary-Bobo and Spiegel (RAND, 2006) show that this kind of lottery is most likely to be locally incentive compatible when the agent is protected by limited liability. In this paper, we investigate how the principal should construct the lottery to attain not only local but also global incentive compatibility. We first assess that the main issue with global incentive compatibility rests with intermediate types being potentially attractive reports to both lower and higher types. We then show that a lottery including three levels of profit (rather than only two) is optimal in that it is most likely to be globally incentive compatible under limited liability, if local incentive constraints are strictly satisfied. We identify conditions under which first best is implemented. In a setting with three types and three signals we also pin down the optimal distortions when those conditions are violated. We show that, if local incentive compatibility is not an issue but first best is beyond reach, then it is generally optimal to concede an information rent to one type only.

Keywords: informative signals, limited liability, conditional probability, incentive compatibility, full-rank condition

JEL Classification: D820

Suggested Citation

Danau, Daniel and Vinella, Annalisa, On the Optimal Use of Correlated Information in Contractual Design Under Limited Liability (April 19, 2018). CESifo Working Paper Series No. 6974, Available at SSRN: https://ssrn.com/abstract=3190980 or http://dx.doi.org/10.2139/ssrn.3190980

Daniel Danau

Université de Caen Basse-Normandie ( email )

Esplanade de la Paix
Caen, 14000
France

Annalisa Vinella (Contact Author)

University of Bari - Department of Economics and Finance ( email )

Piazza Umberto I
Bari, 70121
Italy
+39 080 504 93 40 (Phone)
+39 080 504 91 49 (Fax)

HOME PAGE: http://www.uniba.it/docenti/vinella-annalisa

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