Discussion Paper Details

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Title: A Theory of Threshold Contracts

Author(s): Johannes Gerd Becker and Hans Gersbach

Publication Date: January 2017

Keyword(s): asymmetric information, commitment, principal-agent model, reappointment, repeated game, stationary Markovian strategies, threshold contracts and threshold strategies

Programme Area(s): Industrial Organization and Public Economics

Abstract: We consider an infinitely repeated reappointment game in a principal-agent relationship and examine the consequences of threshold contracts, which forbid reappointment if the principal's utility is too low. Typical examples are voter-politician or government-public servant relationships. The agent chooses costly effort and enjoys being in office until he is deselected. The principal observes a noisy signal of the agent's effort and decides whether to reappoint the agent or not. We analyse the stationary Markovian equilibria of this game with and without threshold contracts. We identify the circumstances under which such threshold contracts are welfare-improving or beneficial for the principal, which, in turn, may justify attempts to introduce such contracts in politics.

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Bibliographic Reference

Becker, J and Gersbach, H. 2017. 'A Theory of Threshold Contracts'. London, Centre for Economic Policy Research.