Working Paper: CEPR ID: DP10180
Authors: Pierre Chaigneau; Alex Edmans; Daniel Gottlieb
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.
Keywords: Contract Theory; Informativeness Principle; Limited Liability; Options; Pay-for-Luck; Principal-Agent Model; Relative Performance Evaluation
JEL Codes: D86; J33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| decrease in signal volatility (C58) | decrease in the value of the call option (G13) |
| decrease in the value of the call option (G13) | benefit to the principal by lowering expected wages (J32) |
| decrease in signal volatility (C58) | alter the agent's effort incentives (J33) |
| initial strike price is low (G13) | decrease in effort incentives due to increased volatility (G40) |
| initial strike price is high (G13) | increase in effort incentives due to increased volatility (G40) |
| increased informativeness (D83) | weakly negative effect on expected wages (J79) |