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Endogenous contractual externalities

Ozdenoren, Emre and Yuan, Kathy (2015) Endogenous contractual externalities. Financial Markets Group Discussion Papers (746). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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We study effort and risk-taking behaviour in an economy with a continuum of principal-agent pairs where each agent exerts costly hidden effort. When the industry productivity is uncertain, agents have motivations to match the industry average effort, which results in contractual externalities. Contractual externalities have welfare changing effects when the information friction is correlated and the industry risk is not revealed. This is because principals do not internalise the impact of their choice on other principals' endogenous industry risk exposure. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivise their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks relative to the second best. The opposite occurs when the expected productivity is low.

Item Type: Monograph (Discussion Paper)
Official URL:
Additional Information: © 2015 The Authors
Divisions: Finance
Systemic Risk Centre
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
G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General
Date Deposited: 21 Jan 2016 14:56
Last Modified: 16 May 2024 12:07
Projects: ES/K002309/1
Funders: ESRC

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