DP5433 Speculative Contracts

Author(s): Kfir Eliaz, Ran Spiegler
Publication Date: December 2005
Keyword(s): menus, non-common priors, speculative trade
JEL(s): D42, D82, L12
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=5433

We propose to view action-contingent contracts as bets, motivated by different prior beliefs between the contracting parties (rather than, say, as an instrument for overcoming moral hazard problems). Such differences in prior beliefs may arise from inherent biases such as over-optimism. Menus of contingent contracts that arise in principal-agent relationships are thus interpreted as a consequence of the principal's attempt to screen the agent's prior belief. Thus, an employer may offer his worker to choose between fixed-wage and profit-sharing schemes, in order to screen the worker's degree of optimism. We present a model of bilateral contracting which captures these ideas, characterize the optimal menu and apply it to a number of economic settings.