Opportunism and Dynamic Contracting

1
Opportunism and Dynamic Contracting

• Dynamic Contracting May Invite Opportunism
• Why?
• Dynamic contracting covers repeated or long term
  transactions
• In these situations, initial contracts may be
  revised as new information arises
• Such information is often an outcome of agents
  earlier behaviors under initial contracts
• Such behaviors will be altered as agents
  anticipate future revision of initial contracts
• There are costs of using information

2
Opportunism and Dynamic Contracting

• Ratchet Effect
• The origin of the concept
• Socialist economies
• The intuition of the idea
• Good performance reveals higher potential
  productivity
• Performance standards tend to be raised
  (ratcheted up) after good performance, or less
  pay for same performance
• Agents are punished for good performance

3
Opportunism and Dynamic Contracting

• Ratchet Effect
• Impact of the ratchet effect
• Agents become less responsive to incentive
  measures in initial contracting for fear of
  revealing their productivity
• The informativeness principle fails
• Possible solutions to the ratchet effect
• Commitment not to use available information
• Surrendering the right or eliminating the motives
  to revise contracts
• Examples

4
Opportunism and Dynamic Contracting

• Ex Post Renegotiation
• Why renegotiate a contract
• Upon arrival of new information, parties on both
  sides of a contract may find it mutually
  beneficial to rescind the original contract and
  have a new one instead
• Example of new information
• Agents behaviors are sunk -- in the case of
  moral hazard
• Agents private information is revealed -- in the
  case of adverse selection

5
Opportunism and Dynamic Contracting

• Ex Post Renegotiation
• Why ex post renegotiation may invite opportunism?
• Anticipating ex post renegotiation, parties may
  not be able to draft the initial contract in a
  way to generate the desired behaviors
• Examples
• Crime and punishment
• Stock options
• Soft budget constraints

6
Opportunism and Dynamic Contracting

• Ex Post Renegotiation
• Trade-off between ex ante efficiency and ex post
  efficiency
• Ex post renegotiation is mutually benefitical and
  thus efficient ex post to parties on both sides
  of the contract
• But the pursuit of ex post efficiency may
  compromise the ex ante efficiency

7
Opportunism and Dynamic Contracting

• Ex Post Renegotiation
• Commitment
• Commitment to the original contracting is called
  if the ex ante efficiency outweighs the ex post
  efficiency
• It is important to remember
• In some cases, the ex post efficiency can
  outweigh the ex ante efficiency
• Example financial contracting and investment
  myopism

8
Commitment

• How to commit
• There are roughly three kinds of approaches
• change information availability that will
  compromise commitment
• change incentives, so there is no reason to
  compromise commitment
• change authorities, so that one cannot choose the
  needed action to compromise commitment

9
Commitment

• How to Commit
• Some examples
• Reputation
• Organization design
• Introducing third parties delegation
• Contracting
• and so forth.

10
Specific Investment Hold-Up Problem

• Hold-up and Specific Investment
• Hold up
• Refers to a situation where one who makes a
  relation-specific investment becomes vulnerable
  to a threat by other parties to terminate that
  relationship. These parties use the threat to
  obtain better terms than were initially
  contracted
• Specific investment
• Refers to investment in an asset that is
  exceptionally valuable only in a particular use
• Example 1 Champaign airport and University of
  Illinois
• Example 2 Operating system and application
  programs

11
Specific Investment Hold-Up Problem

• Hold up and Efficiency
• By itself, hold-up has no effect on efficiency
• Efficient outcome can always be reached through
  bargaining (recall Coase Theorem). Hold-up
  affects only redistribution
• However, hold-up can lead to efficiency loss when
  it deters specific investment ex ante
• Example Suppose U of I bargains with Champaign
  airport to gain concession using threats of
  building bullet train tracks. Anticipating such
  a hold-up behavior, investors may be reluctant to
  invest in Champaign airport

12
Specific Investment Hold-Up Problem

• Hold-up and Incomplete Contract
• Hold-up is possible because certain contingencies
  cannot be contracted x ante
• Such contingencies may nevertheless revealed ex
  post and induce parties to renegotiate
• Hold-up problem can be avoided if contracting
  were perfect

13
Specific Investment Hold-Up Problem

• Hold-up, Bargaining, and Outside Options
• Hold-up and bargaining
• The way in which hold-up affects ex post
  redistribution and therefore ex ante specific
  investment depends on the bargaining structure
• Bargaining and outside options
• A key determinant of bargaining outcomes is
  parties outside options
• Example if demand for Champaign airport does not
  come mostly from U of I, Champaign airport will
  not give in to the threat of U of I. If it is
  extremely costly for U of I to build bullet train
  track, Champaign airport will not give in to the
  threat either

14
Specific Investment Hold-Up Problem

• Hold-up, Specific Investment, and Ownership
• Ownership solution
• When an asset is specific to a particular use,
  the hold-up problem for that asset may be
  alleviated by having the use own the asset
• However, this solution must be weighed against
  the fact that the user may not be in a good
  position to manage the investment

15
Classical Economics of Investment Decisions

• How to evaluate an investment opportunity
• Fisher Separating Theorem
• With perfect capital markets, the evaluation of
  an investment opportunity should be based solely
  on the investment returns and on the cost of
  capital the interest rate. The evaluation will
  not depend on the investors personal consumption
• When does the evaluation depend on person
  consumption?
• When the investor has to finance the investment
  from his/her own budget

16
Classical Economics of Investment Decisions

• Limits to Fisher Separation Theorem
• Measuring returns
• Many benefits in investments are hard to measure
  and tend to be neglected
• In some cases, investments have strategic and
  non-tangible benefits. For example, investment
  in advertisement
• Investment evaluation and incentives
• Often parties in charge of evaluating investment
  opportunities may not share 100 of the return
  and the cost

17
Classical Economics ofFinancial Structure
Decisions

• How to Finance an Investment
• Equity financing or debt financing
• Does it matter?
• Modigliani-Miller Theorem
• Suppose that the investment return is not
  affected by a firms financial structure
  decisions and that investors can borrow on the
  same term as the firm. Then the firms financial
  structure decisions do not affect its value

18
Classical Economics ofFinancial Structure
Decisions

• Modigliani-Miller Theorem
• Illustration
• Suppose the firm generates a fixed amount of
  return X, which will be distributed to its
  investors
• Depending on the financial structure, X may be
  distributed to lenders and equity holders
• Let the amount distributed to lenders be B(1
  r). The amount distributed to equity holders
  will be X - B(1 r)
• To be entitled to such distribution, lenders will
  have to pay the firm B and equity holders will
  have to pay P(X - B(1 r))
• B P(X - B(1 r)) is the value of the firm
• Does the value depend on B?

19
Classical Economics ofFinancial Structure
Decisions

• Modigliani-Miller Theorem
• Illustration
• Answer is no. To see why, consider the following
• Suppose one firm chooses B and the other firm
  chooses B
• If an investor pays the first firm B and P(X -
  B(1 r)), the return distributed to her is B X
  - B(1 r) X
• If this investor pays the second firm B and P(X
  - B(1 r)), the return distributed to her is B
  X - B(1 r) X
• Therefore, B P(X - B(1 r)) must equal B
  P(X - B(1 r))

20
Classical Economics ofFinancial Structure
Decisions

• Implications of Modigliani-Miller Theorem
• Dividend policy and the value of the firm
• One particular implication of MM theorem is the
  irrelevance of dividend payment and the value of
  the firm
• To understand this, realize that the firm can use
  its investment return either to pay dividend or
  reinvest. Dividend payment implies future
  investment has to be financed through equity or
  debt
• If the firm reinvest without paying dividend,
  equity holders equity holding increases
• If the firm pays dividend and finance future
  investment by issuing new equity or debt,
  investors holding of the firm securities will
  increase as well
• According to MM theorem, there is no difference
  between the two

21
Efficient Market Hypothesis

• How Well Asset Prices Reflect Fundamental Values
  of Firms
• Investment evaluation depends on expected returns
• Expectation is a matter of information
• What information does the market use and how
  accurately does it use such information
• Efficient Market Hypothesis
• Share prices are determined according to
  expectations that are based on all relevant
  information

22
Are Capital Markets Efficient?

• Capital Market and Financial Capital Allocation
• Does classical theory indicate efficient
  allocation of capital through capital markets?
• The classical theory suggests that investments
  with positive net present value to be undertaken,
  but not the highest
• Will share price direct financial capital to
  investments with the highest net present value?
• No, because a firm is a collection of
  investments, share price depends on average
  profitability of all these investments rather
  than profitability of new investment

23
Are Capital Markets Efficient?

• Validity of Efficient Market Hypothesis
• Noisy traders
• There are always some ill-informed traders
• Informed parties may not trade
• Trading reveals information, reduces gains from
  trading
• Learning and information aggregation
• When investors are not well-informed, they will
  try to learn from the market
• But the process of information aggregation on the
  market may not be inefficient
• Example information cascade

24
Are Capital Markets Efficient?

• Validity of Efficient Market Hypothesis
• Market Myopism and Managerial Myopism
• It is often easier to gather information about a
  firms short term performance than information
  about a firms long term potential
• This induces managers to devote more resources to
  short term performance
• Self-fulfilling short term behaviors encourage
  market myopism

25
Financial Structure and Corporate Control

• Information Asymmetry and Financial Structure
• Financial structure can affect value of the firm
  by changing payoff structure as well as right
  structure
• Changing managerial incentives
• Affecting conflicts of interest among various
  investors
• Influencing probability of bankruptcy
• Providing incentives for investors to monitor
  management

26
Financial Structure and Corporate Control

• Conflicts of Interest between Management and
  Shareholders
• When management owns only a small fraction of
  shares, management may take actions to benefit
  themselves at the expense of share holders
• minor share holdings by management may be
  inevitable, because of limited financial wealth
  and risk tolerance
• Overcoming free-riding in monitoring
• Concentrated shareholding
• Introducing debt and the risk of bankruptcy

27
Financial Structure and Corporate Control

• Conflicts of Interest between Equity holders and
  Lenders
• Costs of debt
• Debt versus equity and excessive risk taking
• Debt overhang and under-investment
• Strategic asset destruction
• Benefits of debt
• Equity is soft, debt is hard

28
Financial Structure and Corporate Control

• Signaling and Financial Structure Decisions
• Debt and Equity
• Firms with higher expected cash flow faces a
  lower probability of bankruptcy
• Therefore debt financing may signal higher
  expected cash flow, thus better earning prospects
• Dividend policy
• Dividend payment may signal better future earning
  prospect
• Dividend payment may also force a firm to go
  through market for funds, therefore subject it to
  market monitoring

29
Coordination Failure

• Bank Run and Coordination Failure
• The concept of coordination failure
• Referring to a situation where an individual
  takes an efficient action if he/she anticipates
  others to do so too, and the resulting outcome is
  efficient whereas an individual takes an
  inefficient action if he/she anticipates others
  to do so too, and the resulting outcome is
  inefficient
• Bank run
• an example of coordination failure

30
Coordination Failure

• Bank Run and Coordination Failure
• Self-fulfilling prophecy
• Coordination Failure is a matter of expectation
  and has the self-fulfilling phenomenon
• Breaking the self-fulfilling prophecy
• the role of deposit insurance