The Value of Informativeness for Contracting

The Value of Informativeness for Contracting

Pierre Chaigneau, Alex Edmans, Daniel Gottlieb

Series number :

Serial Number: 
442/2014

Date posted :

September 01 2014

Last revised :

October 10 2014
SSRN Suggested citation Download this paper Open PDF Share

Keywords

  • contract theory • 
  • principal-agent model • 
  • Limited Liability • 
  • pay-for-luck • 
  • relative performance evaluation • 
  • options • 
  • Informativeness principle

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.

Authors

Real name: 
Pierre Chaigneau
Real name: 
Daniel Gottlieb