The Value of Informativeness for Contracting / Pierre Chaigneau, Alex Edmans, Daniel Gottlieb.

Format:

Book

Author/Creator:

Chaigneau, Pierre.

Contributor:

National Bureau of Economic Research.

Edmans, Alex.

Gottlieb, Daniel.

Series:

Working Paper Series (National Bureau of Economic Research) no. w20542.

NBER working paper series no. w20542

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2014.

Summary:

The informativeness principle demonstrates qualitative benefits to increasing signal precision. However, it is difficult to quantify these benefits -- and compare them against the costs of precision -- since we typically cannot solve for the optimal contract and analyze how it changes with informativeness. We consider a standard agency model with risk-neutrality and limited liability, where the optimal contract is a call option. The direct effect of reducing signal volatility is a fall in the value of the option, benefiting the principal. The indirect effect is a change in the agent's effort incentives. If the original option is sufficiently out-of-the-money, the agent can only beat the strike price if he exerts effort and there is a high noise realization. Thus, a fall in volatility reduces effort incentives. As the agency problem weakens, the gains from precision fall towards zero, potentially justifying pay-for-luck.

Notes:

Print version record

October 2014.