The value of informativeness for contracting

Chaigneau, Pierre, Edmans, Alex and Gottlieb, Daniel (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:	08 May 2024 22:36
URI:	http://eprints.lse.ac.uk/id/eprint/119024

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