DP10143 The Informativeness Principle Under Limited Liability

Author(s): Pierre Chaigneau, Alex Edmans, Daniel Gottlieb
Publication Date: September 2014
Keyword(s): contract theory, Informativeness principle, limited liability, options, pay-for-luck, principal-agent model, relative performance evaluation
JEL(s): D86, J33
Programme Areas: Labour Economics, Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=10143

This paper shows that the informativeness principle does not automatically extend to settings with limited liability. Even if a signal is informative about effort, it may have no value for contracting. An agent with limited liability is paid zero for certain output realizations. Thus, even if these output realizations are accompanied by an unfavorable signal, the payment cannot fall further and so the principal cannot make use of the signal. Similarly, a principal with limited liability may be unable to increase payments after a favorable signal. We derive necessary and sufficient conditions for signals to have positive value. Under bilateral limited liability and a monotone likelihood ratio, the value of information is non-monotonic in output, and the principal is willing to pay more for information at intermediate output levels.