Citation

Discussion Paper Details

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Title: The Value of Informativeness for Contracting

Author(s): Pierre Chaigneau, Alex Edmans and Daniel Gottlieb

Publication Date: October 2014

Keyword(s): contract theory, informativeness principle, limited liability, options, pay-for-luck, principal-agent model and relative performance evaluation

Programme Area(s): Financial Economics and Labour Economics

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-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.

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Bibliographic Reference

Chaigneau, P, Edmans, A and Gottlieb, D. 2014. 'The Value of Informativeness for Contracting'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10180