Working Paper: NBER ID: w20542
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: Informativeness; Contracting; Agency Problem; Signal Precision
JEL Codes: D86; J33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increasing informativeness (D83) | decreasing the value of the agent's call option (G19) |
| decreasing the value of the agent's call option (G19) | benefiting the principal (G14) |
| increased informativeness (D83) | altering the agent's effort incentives (J33) |
| decrease in volatility (G17) | weakening the agent's incentives to exert effort (D82) |
| increased informativeness (severe agency problem) (D82) | enhancing effort incentives (J33) |
| increased informativeness (weak agency problem) (D82) | reducing incentives (H23) |