CONTRACT THEORY Ph.D. course, Stockholm University 2012 Jens Josephson

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1 CONTRACT THEORY Ph.D. course, Stockholm University 2012 Jens Josephson ABSTRACT This course will provide an overview of important areas of the economics of information. It will cover classic papers of contract design under asymmetric information (moral hazard and adverse selection models), mechanism design and auctions, and, if time permits, also reputation. EXAMINATION The examination will consist of weekly problem sets, presentations of articles, and an exam. TOPICS 1. MORAL HAZARD I: STATIC BILATERAL 2. MORAL HAZARD II: MULTIAGENT AND DYNAMIC 3. ADVERSE SELECTION I: STATIC BILATERAL 4. ADVERSE SELECTION II: DYNAMIC, SIGNALING, AND CHEAP TALK 5. AUCTIONS AND MECHANISM DESIGN 6. REPUTATION LITERATURE General Treatments Bergin, J. (2005). Microeconomic Theory. Oxford University Press. *Bolton, P. and M. Dewatripont (2005), Contract Theory. The MIT Press. Fudenberg and Tirole (1991), Game Theory. The MIT Press. Jehle, P. and P. J. Reny (2000), Advanced Microeconomic Theory, 2 nd ed., Addison-Wesley. Laffont, J-J. and D. Martimort (2002), The Theory of Incentives, Princeton University Press. * Mas-Collel A., Whinston, M.D., and J.R. Green (1995), Microeconomic Theory, Oxford University Press. Osborne and Rubinstein (1994), A Course in Game Theory, MIT Press. Perez, Castrillo, D. and Macho Stadler, I. (2001), An introduction to the economics of information, 2 nd ed., Oxford University Press. Salanié, Bernard (2005). The Economics of Contracts: A Primer. 2 nd ed. Cambridge, MA: MIT Press. 0. Introduction *Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 1: Introduction * 1(5)

2 1. Moral Hazard I: Static bilateral Aggarwal, R.K., and A.A. Samwick (1999), The Other Side of the Trade-Off: The Impact of Risk on Executive Compensation, Journal of Political Economy, 107(1), *Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 4: Moral Hazard, and chapter 6.2: Multidimensional incentive problems. * Holmstrom, B. (1979). "Moral Hazard and Observability." Bell Journal of Economics: 10: * Holmstrom, B. and P. Milgrom (1991), Multi-Task Principal-Agent Analyses, Journal of Law, Economics and Organization, 7, Special Issue. Jewitt, I. (1988), Justifying the First-Order Approach to Principal-Agent Problems, Econometrica 56: Mirrlees, J. (1999), The Theory of Moral Hazard and Unobservable Behavior, Review of Economic Studies 66: Perez, Castrillo, D. and Macho Stadler, I. (2001), An introduction to the economics of information, 2nd Edition, Oxford University Press. Rogerson, W. (1985), The First-Order Approach to Principal-Agent Problems, Econometrica 53: Moral hazard II: a) Multiagent * Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 8: Multiagent Moral Hazard and Collusion. Green, J. and N. Stokey (1983), "A Comparison of Tournaments and Contracts." Journal of Political Economy, 91: * Holmstrom, B. (1982). "Moral Hazard in Teams." Bell Journal of Economics: 13: Holmstrom, B. and P. Milgrom (1990), Regulating Trade Among Agents, Journal of Institutional and Theoretical Economics, 146(1): Itoh, H. (1991), Incentives to Help in Multi-Agent Situations, Econometrica, 59(3): Lazear, E. and S. Rosen. (1981). "Rank-Order Tournaments as Optimum Labor Contracts." Journal of Political Economy, 89: Legros, P. and S. Matthews (1993), Efficient and Nearly Efficient Partnerships, Review of Economic Studies 6): b) Dynamic * Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 10: Dynamic Moral Hazard. * Chiappori, P.A., I. Macho, P. Rey and B. Salanie (1994), Repeated Moral Hazard: The Role of Memory, Commitment and the Access to Credit Markets, European Economic Review 38(8), Dewatripont, M., I. Jewitt, and J. Tirole. (1999). "The Economics of Career Concerns, Parts I & II." Review of Economic Studies 66: Fudenberg, D., Holmstrom, B. and P. Milgrom (1990), Short Term Contracts and Long Term Agency Relationships, Journal of Economic Theory, 51(1): Fudenberg, D., and J. Tirole (1990). Moral Hazard and Renegotiation in Agency Contracts, Econometrica 58(6): Hermalin, B. and M. Katz. (1991). "Moral Hazard and Verifiability: The Effects of Renegotiation in Agency." Econometrica, 59(6): * Holmstrom, B. (1982). "Managerial Incentive Problems--A Dynamic Perspective." Republished in Review of Economic Studies 66 (1999): * Holmstrom, B. and P. Milgrom (1987), Aggregation and Linearity in the Provision of Intertemporal Incentives, Econometrica, 55(2): Radner, R. (1981), Monitoring Cooperative Agreements in a Repeated Principal-Agent Relationship, Econometrica, 49(5): Rogerson, W. (1985), Repeated Moral Hazard, Econometrica, 53: Sannikov, Y. (2008), A Continuous-Time Version of the Principal-Agent Problem, Review of Economic Studies 73(3): (5)

3 3. Adverse Selection I: Screening Adams, W. and J. Yellen (1976), Commodity bundling and the burden of monopoly, Quarterly Journal of Economics 90: Baron, D. and R. Myerson (1982), Regulating a Monopolist with Unknown Costs, Econometrica, 50(4): * Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 2: Adverse selection: screening, and chapter 6: Multidimensional incentive problems. Laffont, J-J and J. Tirole (1986), Using Cost Observation to Regulate Firms, Journal of Political Economy, 94(3). * Maskin, E. and J. Riley (1984), Monopoly with Incomplete Information, Rand Journal of Economics, 15: Mirrlees, J. (1971), An exploration in the theory of optimum income taxation, Review of Economic Studies 38: Mussa, M. and S. Rosen (1978), Monopoly and Product Quality, Journal of Economic Theory, 18: * Riley, J.G. (2001), Silver signals: Twenty-five years of screening and signaling. J Econ Lit 39(2), Rochet, J.C. and L. Stole (2003), The Economics of Multidimensional Screening," in M. Dewatripont, L. Hansen, and S. Turnovsky (Eds), Advances in Economics and Econometrics, Cambridge University Press. * Rotschild, M., and J. Stiglitz (1976), Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Information, The Quarterly Journal of Economics 90(4), Tirole, J. (1986), Hierarchies and Bureaucracies: On the Role of Collusion in Organizations Journal of Law, Economics and Organization, II(2): Tirole, J. (1992), Collusion and the Theory of Organizations, in J.-J. Laffont (ed.), Advances in Economic Theory: Sixth World Congress, Volume 2, Econometric Society, Cambridge University Press, Adverse Selection II: a) Signaling, and Cheap Talk * Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 3: Hidden Information, Signaling and chapter 13.1: Markets and Contracts. Choo, I.-K. and D.M. Kreps (1987), Games and Stable Equilibria, The Quarterly Journal of Economics 102(2), Crawford, V. P. and Sobel, J. (1982), Strategic Information Transmission, Econometrica 50(6): * Riley, J.G. (2001), Silver signals: Twenty-five years of screening and signaling. J Econ Lit 39(2), *Farrell, J. and Rabin, M. (1996), Cheap Talk, The Journal of Economic Perspectives, Vol. 10, No. 3, b) Dynamic * Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 9: Dynamic Adverse Selection. Dewatripont, M. (1989), Renegotiation and Information Revelation over Time: The Case of Optimal Labor Contracts, Quarterly Journal of Economics, 104: Dewatripont, M. and Maskin, E. (1990), Contract Renegotiation in Models of Asymmetric Information, European Economic Review, 34(2-3): Dewatripont, M. and Maskin, E. (1995), Credit and Efficiency in Centralized and Decentralized Economies, Review of Economic Studies 62(4), Diamond, D. (1989), Reputation Acquisition in Debt Markets, Journal of Political Economy, 97(4), Hart, O. and J. Tirole (1988), Contract Renegotiation and Coasian Dynamics, Review of Economic Studies, 55: (5)

4 Laffont, J.-J. and J. Tirole (1988), The Dynamics of Incentive Contracts, Econometrica, 56(5): Laffont, J.-J. and J. Tirole (1990), Adverse Selection and Renegotiation in Procurement, Review of Economic Studies, 57: * Townsend, R. (1982), Optimal Multiperiod Contracts and the Gain from Enduring Relationships under Private Information, Journal of Political Economy, 90, Auctions and Mechanism Design * Bolton, P. and M. Dewatripont (2005), Contract Theory, chapter 7: Multiagent adverse selection. Cremer, J. and R. McLean (1988), Full Extraction of the Surplus in Bayesian and Dominant Strategy Auctions," Econometrica 56, d'aspremont, C. and L. Gerard-Varet (1979), Incentives and Incomplete Information, Journal of Public Economics, 11: Jackson, M. (2003), Mechanism Theory, mimeo. ( Jackson, M. (2001), A crash course in implementation theory, Social Choice and Welfare 18:4, Krishna, V. (2002), Auction Theory, Academic Press. Mas-Collel A., Whinston, M.D., and J.R. Green (1995), Microeconomic Theory, chapter 23: Incentives and Mechanism Design. Maskin, E. and J. Riley (1984), Optimal Auctions with Risk-Averse Buyers, Econometrica 52(6): Milgrom, P. and R. Weber (1982), A Theory of Auctions and Competitive Bidding, Econometrica 50(5): Milgrom, P.(2004), Putting Auction Theory to work, Cambridge University Press. * Myerson, R. (1981), Optimal Auction Design, Mathematics of Operations Research, 6: Myerson, R. and M. Satterthwaite (1983), Efficient Mechanisms for Bilateral Trading, Journal of Economic Theory, 29: Reputation * Bar-Isaac, H. (2003), Reputation and survival: Learning in a dynamic signalling model. Review of Economic Studies 70, * Bar-Isaac, H. and S. Tedelis (2008), Seller Reputation, Foundations and trends in Microeconomics 4:4, Cripps, M. W. (2006), Reputation. New Palgrave Dictionary of Economics, second edition. * Holmstrom, B. (1982). "Managerial Incentive Problems--A Dynamic Perspective." Republished in Review of Economic Studies 66 (1999): Klein, B. and K. B. Leffler (1981), The role of market forces in assuring contractual performance. Journal of Political Economy 89, Mailath, G. J. and L. Samuelson (2001), Who wants a good reputation?, Review of Economic Studies 68, * Tadelis, S. (1999), What s in a name? Reputation as a tradeable asset. American Economic Review 89, Presentations Pick an article on information economics of your choice either among the ones listed below or a different one but check your choice with me before you start preparing your presentation. Besley, T. and S. Coate (1995), Group lending, repayment incentives and social collateral, Journal of Development Economics 46, Bolton, P., Freixas, X., and J. D. Shapiro (2012), The Credit Ratings Game, Journal of Finance 67(1), (5)

5 Calvo, G. and S. Wellisz (1978), Supervision, Loss of Control, and the Optimum Size of the Firm, Journal of Political Economy 75: Che, Y.-K., and S.-W. Yoo (2001), "Optimal Incentives for Teams." American Economic Review 91, no. 3, Crawford, V.P., and J. Sobel (1982) "Strategic Information Transmission." Econometrica, Vol 50, No. 6, Dewatripont, M. and J. Tirole (1999), Advocates, Journal of Political Economy, 107(1), Gayle, G.-L., and R.A. Miller (2009), "Has Moral Hazard Become a More Important Factor in Managerial Compensation?," American Economic Review 99(5): Hart, O. and J. Moore. (2004),"Agreeing Now to Agree Later: Contracts that Rule Out but do not Rule In." National Bureau of Economic Research Working Paper No Kocherlakota, N. (1996), "Implications of Efficient Risk Sharing without Commitment," Review of Economic Studies 63, Lavy, V. (2009), "Performance Pay and Teachers' Effort, Productivity, and Grading Ethics." American Economic Review, 99(5), Laffont, J.-J., and T. N Guessan (2000), Group lending with adverse selection, European Economic Review 44, Laffont, J.-J., and M. Salah Matoussi (1995), Moral Hazard, Financial Constraints and Sharecropping in El Oulja, The Review of Economic Studies, Vol. 62, No. 3, Levin, J. (2003). "Relational Incentive Contracts," American Economic Review 93, no. 3, Lewis T.R., and D.E.M. Sappington (1993), Ignorance in Agency Problems, Journal of Economic Theory 61:1, Maskin, E. and J. Tirole. "Unforeseen Contingencies and Incomplete Contracts." Review of Economic Studies 66 (1999): Qian, Y. (1994), Incentives and Loss of Control in an Optimal Hierarchy, Review of Economic Studies 61, Rayo, L. (2007), Relational Incentives and Moral Hazard in Teams, Review of Economic Studies, Volume 74 Issue 3, Tirole, J. (2003) "Inefficient Foreign Borrowing: A Dual- and Common-Agency Perspective." American Economic Review 93, no. 5, Townsend, R. M. (1979), Optimal contracts and competitive markets with costly state verification, Journal of Economic Theory, Volume 21, Issue 2, Prerequisites I will assume a basic knowledge of the following: First-order stochastic dominance Expected utility and risk-aversion Optimization with inequality constraints: Kuhn-Tucker Basic game theory: o Dominated strategies o Nash Equilibrium o Games of incomplete information o Bayesian (Nash) Equilibrium o Subgame-perfect Equilibrium o (Weak) Perfect Bayesian Equilibrium o Notions of repeated games (such as MWG 12.D) 5(5)