Working Paper: CEPR ID: DP10052
Authors: Emre Ozdenoren; Kathy Yuan
Abstract: We study ffort and risk-taking behaviour in an economy with a continuum of principal-agent pairs where each agent exerts costly hidden effort. When the industry productivity is uncertain, agents have motivations to match the industry average effort, which results in contractual externalities. Contractual externalities have welfare changing effects when the information friction is correlated and the industry risk is not revealed. This is because principals do not internalize the impact of their choice on other principals' endogenous industry risk exposure. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivise their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks relative to the second best. The opposite occurs when the expected productivity is low.
Keywords: boombust; effort exertion; contractual externalities; relative and absolute performance contracts; risk taking
JEL Codes: D86; G01; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expected productivity is high (E23) | Over-incentivization of agents (L85) |
| Over-incentivization of agents (L85) | Excessive agent effort (L85) |
| Excessive agent effort (L85) | Increased exposure to industry risks (G32) |
| Expected productivity is low (D24) | Insufficient incentive provision (D52) |
| Insufficient incentive provision (D52) | Reduced agent effort (L85) |
| Agent effort choices (D82) | Industry average effort (C89) |
| Industry average effort (C89) | Individual agents' risk exposure (G52) |