The value of informativeness for contracting

Chaigneau, Pierre, Edmans, Alex and Gottlieb, Daniel ORCID: 0000-0002-0555-6185 (2014) The value of informativeness for contracting. Financial Markets Group Discussion Papers (737). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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Abstract

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-oft 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.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2014 The Authors
Divisions:	Management
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D86 - Economics of Contract: Theory J - Labor and Demographic Economics > J3 - Wages, Compensation, and Labor Costs > J33 - Compensation Packages; Payment Methods
Date Deposited:	08 Jun 2023 13:48
Last Modified:	16 Sep 2023 00:01
URI:	http://eprints.lse.ac.uk/id/eprint/119024

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