DP10180 The Value of Informativeness for Contracting

Author(s): Pierre Chaigneau, Alex Edmans, Daniel Gottlieb
Publication Date: October 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=10180

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-of-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.