The Royal Swedish Academy of Sciences has awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016 to: Oliver Hart Harvard University, Cambridge, MA, USA Bengt Holmström Massachusetts Institute of Technology, Cambridge, MA, USA for their contributions to contract theory.

You can view Bengt Holmstrom and Barry Nalebuff’s paper, “To The Raider Goes The Surplus? A Reexamination of the Free-Rider Problem,” in the Spring 1992 issue of JEMS.

Press Release: The Prize in Economic Sciences 2016

10 October, 2016

This paper reexamines Grossman and Hart’s (1980) insight into how the free-rider problem excludes an external raider from capturing the increase in value it brings to a firm. The inability of the raider to capture any of the surplus depends critically on the assumption of equal and indivisible shareholdings–the one-share-per-shareholder model. In contrast, we show that once shareholdings are large and potentially unequal, a raider may capture a significant part of the increase in value. Specifically, the free-rider problem does not prevent the takeover process when shareholdings are divisible.

Read Full Paper found here: →

Feature Article

Volume 25, Winter 2016

The Effect of Performance Standards on Health Care Provider Behavior: Evidence from Kidney Transplantation

Sarah Stith and Richard Hirth

Performance standards are designed to ensure a basic level of quality, and through public reporting of firm performance, encourage firms to compete on quality thus allowing the market to determine the optimal level of quality. In markets with substantial excess demand, however, demand effects may be insufficient to induce any change in firm behavior and enforcement may be required to ensure high quality. Even with enforcement, quality still may not improve at underperforming firms if gaming the system is less costly than improving quality. We test whether information alone or with regulatory enforcement improves outcomes or elicits gaming behavior in our study of 266 kidney transplant centers between 2001 and 2012. In a context of excess demand induced by price controls, we show that information alone has no impact and enforcement may actually increase market inefficiencies; firms respond to costly quality requirements, not by improving quality, but by reducing supply, which exacerbates the disequilibrium between supply and demand, and by cream-skimming, which reduces access to transplantation among sicker patients.

Read more

Sarah Stith

Recently Published Articles

Volume 25, Issue 2, Summer 2016


The Role of Coordination Bias in Platform Competition

Hanna Hałaburda and Yaron Yehezkel
This paper considers platform competition in a two-sided market that includes buyers and sellers. One of the platforms benefits from a favorable coordination bias in the market, in that for this platform it is less costly than for the other platform to convince customers that the two sides will coordinate on joining it. We find that the degree of the coordination bias affects the platform's decision regarding the business model (i.e., whether to subsidize buyers or sellers), the access fees, and the size of the platform. A slight increase in the coordination bias may induce the advantaged platform to switch from subsidizing sellers to subsidizing buyers, or induce the disadvantaged platform to switch from subsidizing buyers to subsidizing sellers. Moreover, in such a case the advantaged platform switches from oversupplying to undersupplying sellers, and the disadvantaged platform switches from undersupplying to oversupplying sellers.

Endogenous Group Formation in Contests: Unobservable Sharing Rules

Kyung Hwan Baik
We study contests in which players compete by expending irreversible effort to win a prize, the prize is awarded to one of the players, the winner shares the prize with other players in his group, if any, and each group's sharing rule is unobservable to the other groups and the singletons, if any, when the players expend their effort. The number of groups, their sizes, and the number of singletons are exogenous in the first model, whereas they are endogenous in the second model. We show that group formation occurs if the number of players is four or smaller, but does not occur otherwise. We examine the effect of endogenous group formation on total effort level and the profitability of endogenous group formation. In each of the two models, comparing the outcomes of the case of unobservable sharing rules with those of the case of observable sharing rules, we show that the two cases yield quite different outcomes.

Performance Pay and Offshoring

Elias Dinopoulos and Theofanis Tsoulouhas
In this paper, we construct a North–South general equilibrium model of offshoring, highlighting the nexus among endogenous effort-based labor productivity and the structure of wages. Offshoring is modeled as international transfer of management practices and production techniques that allow Northern firms to design and implement performance compensation contracts. Performance–pay contracts address moral hazard issues stemming from production uncertainty and unobserved worker effort. We find that worker effort augments productivity and compensation of those workers assigned to more offshorable tasks. An increase in worker effort in the South, caused by a decline in offshoring costs, an increase in worker skill, or a decline in production uncertainty in the South, increases the range of offshored tasks and makes workers in the North and South better off. An increase in Southern labor force increases the range of offshored tasks, benefits workers in the North, and hurts workers in the South. International labor migration from low-wage South to high-wage North shrinks the range of offshored tasks, makes Northern workers worse off and Southern workers (emigrants and those left behind) better off. Higher worker effort in the North, caused by higher worker skills or lower degree of production uncertainty, decreases the range of offshored tasks and benefits workers in the North and South.

Strategic and Natural Risk in Entrepreneurship: An Experimental Study

John Morgan, Henrik Orzen, Martin Sefton and Dana Sisak
We report on the results of experiments where participants choose between entrepreneurship and an outside option. Entrepreneurs enter a market and then make investment decisions to capture value. Payoffs depend on both strategic risk (i.e., the investments of other entrepreneurs) and natural risk (i.e., luck). Absent natural risk, participants endogenously sort themselves into entrepreneurial and safe types, and returns from the two paths converge. Adding natural risk fundamentally changes these conclusions: Here we observe excessive entry and excessive investment so that entrepreneurs earn systematically less than the outside option. These payoff differences persist even after many repetitions of the task. With a risky outside option, entry further increases and about one-third of entrepreneurs adopt a passive strategy, investing little or nothing. Finally, we examine an environment where an individual must become an entrepreneur but chooses the stakes over which she will compete. Due to under-entry and under-investment in the high stakes setting, the returns gap grows to over 15 percentage points. A two-factor model incorporating loss aversion and love of winning can rationalize these returns patterns.

Buying Decision Coordination and Monopoly Pricing of Network Goods

Pekka Sääskilahti
We analyze how uncertainty about consumers' preferences affects the pricing of a network device and the interaction usage it enables. A premium device price may give high hardware profits, but adoption will be low reducing the profits from interaction services. The firm internalizing this adjusts its hardware price downward, and prices as if it was getting the maximal interaction usage profits from the full network. Profits decrease in uncertainty, whereas consumer surplus increases in uncertainty, but only if the level of uncertainty is high. Bundling the device and services is profitable if uncertainty relates mostly to consumers' private information.

Capacity Investment under Demand Uncertainty: The Role of Imports in the U.S. Cement Industry

Guy Meunier, Jean-Pierre Ponssard and Catherine Thomas
Demand uncertainty is thought to influence irreversible capacity decisions. Suppose that local demand can be sourced from domestic (rigid) production or from (flexible) imports. This paper shows that the optimal domestic capacity is either increasing or decreasing with demand uncertainty, depending on the relative level of the costs of domestic production and imports. We test this relationship with data from the U.S. cement industry, in which the difference in marginal cost between domestic production and imports varies across local U.S. markets because cement is costly to transport over land. Industry data for 1999 to 2010 are consistent with the predictions of the model. The introduction of two technologies to the production set—one rigid and one flexible—is crucial to understanding the relationship between capacity choice and uncertainty in this industry because there is no relationship between these two variables in aggregated U.S. data. Our analysis reveals that the relationship is negative in coastal districts, and significantly more positive in landlocked districts.

Career Concerns and Product Market Competition

Fabio Feriozzi
This paper studies the effect of increased competition in the product market on managerial incentives. I propose a simple model of career concerns where firms are willing to pay for managerial talent to reduce production costs, but also to subtract talented executives from competitors. This second effect is privately valuable to firms, but is socially wasteful. As a result, equilibrium pay for talent can be inefficiently high and career concerns too strong. Explicit incentive contracts do not solve the problem, but equilibrium pay is reduced if managerial skills have firm-specific components, or if firms are heterogeneous. In this second case, managers are efficiently assigned to firms, but equilibrium pay reflects the profitability of talent outside the efficient allocation. The effect of increased competition is ambiguous in general, and depends on the profit sensitivity to cost reductions. This ambiguity is illustrated in two examples of commonly used models of imperfect competition.

The Welfare Effects of Consumers' Reports of Bribery

J. Atsu Amegashie
A primary means of bureaucratic oversight is consumer complaints. Yet this important control mechanism has received very little attention in the literature on corruption. I study a signaling game of corruption in which uninformed consumers require a government service from informed officials. A victim of corruption can report corrupt officials whose supervisors are negligent or conscientious but an official's type is his private information. I find that social welfare may be nonmonotonic in the proportion of conscientious supervisors. Several examples show that an increase in the proportion of conscientious supervisors decreases social welfare if the mass of conscientious supervisors is below a critical level. I find that this perverse result does not hold if (a) the bribe is very large, or (b) bribe-giving is legalized. I also find that there is an equilibrium in which no one reports corruption.

Leveraging of Reputation through Umbrella Branding: The Implications for Market Structure

Eric B. Rasmusen
The Klein–Leffler model explains how fear of reputation loss can induce firms to produce high-quality experience goods. This paper shows that reputation can be leveraged across products via umbrella branding, but only by a firm with a monopoly on at least one product. Such a firm may be able to capture a market by using umbrella branding to make high quality credible at a lower price than the incumbent competitive firms. If monopolists compete for this capture, consumers are left better off than if the market remained competitive, in some cases even though the price increases.

Volume 24
Issue 3

Volume 24, Issue 3, Fall 2015


Product Unbundling in the Travel Industry: The Economics of Airline Bag Fees

Jan K. Brueckner, Darin N. Lee, Pierre M. Picard, and Ethan Singer
This paper provides theory and evidence on airline bag fees, offering insights into a real-world case of product unbundling. The theory predicts that an airline's fares should fall when it introduces a bag fee, but that the full-trip price (the bag fee plus the new fare) could either rise or fall. The empirical evidence presented in the paper provides strong confirmation of the first prediction. The data also suggest that the average fare falls by less than the bag fee itself so that the full price of a trip rises for passengers who choose to check bags.

Altruism and Relational Incentives in the Workplace

Robert Dur and Jan Tichem
This paper studies how altruism between managers and employees affects relational incentive contracts. To this end, we develop a simple dynamic principal–agent model where both players may have feelings of altruism or spite toward each other. The contract may contain two types of incentives for the agent to work hard: a bonus and a threat of dismissal. We find that altruism undermines the credibility of a threat of dismissal but strengthens the credibility of a bonus. Among others, these two mechanisms imply that higher altruism sometimes leads to higher bonuses, whereas lower altruism may increase productivity and players' utility in equilibrium.

Management Changes, Reputation, and “Big Bath”—Earnings Management

Petra Nieken and Dirk Sliwka
We study the effects of managerial turnover on earnings management activities in a model in which managers care about their external reputation. We develop an overlapping generations model showing that both outgoing and incoming managers bias reported earnings such that typically very low returns are reported in the first period after a manager has been replaced. Outgoing managers shift earnings forward to their last period in office as they will not benefit from earnings realized after that. Incoming managers can have an incentive to shift earnings to the second period in office as reported earnings will, immediately after a management change, only be partly attributed to their own ability. Deferred compensation can reduce incentives for earnings management.

Price Discrimination under Customer Recognition and Mergers

Rosa-Branca Esteves and Helder Vasconcelos
This paper studies the interaction between horizontal mergers and price discrimination by endogenizing the merger formation process in the context of a repeated purchase model with two periods and three firms wherein firms may engage in behavior-based price discrimination (BBPD). From a merger policy perspective, this paper's main contribution is twofold. First, it shows that when firms are allowed to price discriminate, the (unique) equilibrium merger gives rise to significant increases in profits for the merging firms (the ones with information to price discriminate), but has no ex-post effect on the outsider firm's profitability, thereby eliminating the so-called (static) “free-riding problem.” Second, this equilibrium merger is shown to increase industry profits at the expense of consumers' surplus, leaving total welfare unaffected. This then suggests that competition authorities should scrutinize with greater zeal mergers in industries where firms are expected to engage in BBPD.

Consumer Standards as a Strategic Device to Mitigate Ratchet Effects in Dynamic Regulation

Raffaele Fiocco and Roland Strausz
Strategic delegation to an independent regulator with a pure consumer standard improves dynamic regulation by mitigating ratchet effects associated with short-term contracting. A pure consumer standard alleviates the regulator's myopic temptation to raise output after learning the firm is inefficient. Anticipating this tougher regulatory behavior, efficient firms find it less attractive to exaggerate costs. This reduces the need for long-term rents and mitigates ratchet effects. A welfare standard biased toward consumers entails, however, allocative costs arising from partial separation of the firms' cost types. A trade-off results, which favors strategic delegation when efficient firms are relatively likely.

Information Sharing in Contests

Dan Kovenock, Florian Morath and Johannes Münster
We study the incentives to share private information ahead of contests, such as markets with promotional competition, procurement contests, or research and development (R&D). We consider the cases where firms have (i) independent values and (ii) common values of winning the contest. In both cases, when decisions to share information are made independently, sharing information is strictly dominated. With independent values, an industry-wide agreement to share information can arise in equilibrium. Expected effort is lower with than without information sharing. With common values, an industry-wide agreement to share information never arises in equilibrium. Expected effort is higher with than without information sharing.

Endowment Origin, Demographic Effects, and Individual Preferences in Contests

Curtis R. Price and Roman M. Sheremeta
In modern firms the use of contests as an incentive device is ubiquitous. Nonetheless, experimental research shows that in the laboratory subjects routinely make suboptimal decisions in contests even to the extent of making negative returns. The purpose of this study is to investigate how earning the endowment, demographic differences, and individual preferences impact behavior in contests. To this end, we conduct a laboratory experiment in which subjects expend costly resources (bids) to attain an award (prize). In line with other laboratory studies of contests, our results show that subjects overbid relative to theoretical predictions and incur substantial losses as a result. Making subjects earn their initial resource endowments mitigates overbidding and thus increases efficiency. Overbidding is linked to gender, with women bidding higher than men and having lower average earnings. Other demographic information, such as religiosity, and individual preferences, such as preferences toward winning and risk, also influence behavior in contests.

Vertical Foreclosure Using Exclusivity Clauses: Evidence from Shopping Malls

Itai Ater
Exclusive contracts are one of the most controversial topics in the economic analysis of antitrust. Yet, very few empirical papers analyze the determinants and the consequences of exclusive contracts. In this paper, I study exclusive contracts between hamburger restaurants and Israeli shopping malls, in which mall owners commit to prohibiting additional hamburger restaurants from entering their malls. I investigate the determinants of these exclusive contracts and examine how such contracts affect the number of hamburger restaurants and their sales. I show that exclusive contracts are less likely to be adopted in larger malls, in malls that face more competition from other malls, and in malls that opened before 1993, when McDonald's and Burger King entered the Israeli market. I then use the mall's opening year—before or after 1993—as an instrumental variable to estimate a negative effect of exclusive contracts on the number of restaurants and on total mall hamburger sales. My findings are generally consistent with anti-competitive vertical foreclosure models.

Doing Well by Doing Good? Community Development Venture Capital

Anna Kovner and Josh Lerner
This paper examines the investments and performance of community development venture capital (CDVC). We find substantial differences between CDVCs and traditional VCs: CDVC investments are far more likely to be in nonmetropolitan regions and in regions with little prior venture activity. CDVC investments are likely to be in earlier stage investments and in industries outside the venture capital mainstream that have lower probabilities of successful exit. Even after controlling for this unattractive transaction mixture, the probability of a CDVC investment being successfully exited is lower. One benefit of CDVCs may be their effect in bringing traditional VCs to underserved regions—controlling for the presence of traditional VC investments, each additional CDVC investment results in an additional 0.06 new traditional VC firms in a region.

Volume 24

Issue 2, Summer 2015
Special Issue: Innovation Economics


The 2011 America Invents Act: Does it Undermine Innovation?

Kaz Miyagawa
With the 2011 America Invents Act, the United States discarded its century-old first-to-invent patent-awarding system in favor of a first-to-file rule. Critics have argued that the first-to-file rule rewards speed in patent applications rather than creativity, thereby undermining innovation. We evaluate this concern within a dynamic model of a patent race, and find first-to-invent (weakly) more conducive to innovation than first-to-file. Defending prior users’ rights can promote both pro- and anti-R&D effect of a switch to first-to-file.

Business Partners: Complementary Assets, Financing, and Invention Commercialization

Thomas Åstebro and Carlos J. Serrano
This paper assesses the relative importance of the complementary assets and financial capital that business partners may add to the original inventor-entrepreneur. Projects run by partnerships were five times as likely to reach commercialization as those without business partners, and they had mean revenues approximately 10 times as great as projects run by solo entrepreneurs. These gross differences may be due both to partners impacting business success that is, who the particular partners were, and to selection of the type of project or of whom to select as a partner. After controlling for selection effects and observed/unobserved heterogeneity, the smallest estimate of partners' complementary assets approximately doubles the probability of commercialization and increases expected revenues by 29% at the sample mean. Our findings suggest that a critical policy option to increase commercialization rates and revenues for early-stage businesses is to support the market for finding skilled partners.

Crowdfunding: Geography, Social Networks, and the Timing of Investment Decisions

Ajay Agrawal, Christian Catalini, and Avi Goldfarb
We examine a crowdfunding platform that connects artists with funders. Although the Internet reduces many distance-related frictions, local and distant funders exhibit different funding patterns. Local funders appear less responsive to information about the cumulative funds raised by an artist. However, this distance effect appears to proxy for a social effect: it is largely explained by funders who likely have an offline social relationship with the artist (“friends and family”). Yet, this social effect does not persist past the first investment, suggesting that it may be driven by an activity like search but not monitoring. Thus, although the platform seems to diminish many distance-sensitive costs, it does not eliminate all of them. These findings provide a deeper understanding of the abilities and limitations of online markets to facilitate transactions and convey information between buyers and sellers with varying degrees of social connectedness.

Executive Pay, Innovation, and Risk-Taking

Volker Laux
This paper analyzes the optimal equity pay mix in a setting in which executives face career concerns and must be motivated to search for innovative investment ideas and to make appropriate decisions regarding whether to pursue the uncovered idea. I show that, depending on the value of the firm's potential growth opportunities and the CEO's concern about being fired, the CEO is either tempted to overinvest in risky ideas (excessive risk-taking) or underinvest in risky ideas (excessive conservatism). The optimal pay package consists of stock options, to encourage the discovery of innovative ideas, and either restricted stock, to combat excessive risk-taking, or severance pay, to combat excessive conservatism. The model provides new empirical predictions relating executive pay arrangements to the importance of innovation and career concerns and analyzes how the change in the economic environment caused by the current financial crisis might change the optimal mix of stock options, restricted stock, and severance pay.

Investment Incentives in Open-Source and Proprietary Two-Sided Platforms

Ramon Casadesus-Masanell and Gastón Llanes
We study incentives to invest in platform quality in open-source and proprietary two-sided platforms. Open platforms have open access, and developers invest to improve the platform. Proprietary platforms have closed access, and investment is done by the platform owner. We present five main results. First, open platforms may benefit from limited developer access. Second, an open platform may lead to higher investment than a proprietary platform. Third, opening one side of a proprietary platform may lower incentives to invest in platform quality. Fourth, the structure of access prices of the proprietary platform depends on (i) how changes in the number of developers affect the incentives to invest in the open platform, and (ii) how investment in the open platform affects the revenues of the proprietary platform. Finally, a proprietary platform may benefit from higher investment in the open platform. This result helps to explain why the owner of a proprietary platform such as Microsoft has chosen to contribute to the development of Linux.

Information Acquisition and Innovation under Competitive Pressure

Andrei Barbos
This paper studies information acquisition under competitive pressure and proposes a model to examine the relationship between product market competition and the level of innovative activity in an industry. Our paper offers theoretical support for recent empirical results that point to an inverted-U shape relationship between competition and innovation. The model presents an optimal timing decision problem where a firm endowed with an idea trades the benefits of waiting for additional information on whether this idea can be converted into a successful project against the cost of delaying innovation: a given firm's profit following innovation is decreasing in the number of firms that invested at earlier dates. By recognizing that a firm can intensify its innovative activity on two dimensions, a risk dimension and a quantitative dimension, we show that firms solve this trade-off precisely so as to generate the inverted-U shape relationship. The dynamic setup of our model offers insights not just in the cross-section on the relationship between competition and innovation, but also intertemporally on the optimal timing of innovation at firm level.

Optimal Production Channel for Private Labels: Too Much or Too Little Innovation?

Claire Chambolle, Clémence Christin, and Guy Meunier
We analyze the impact of the private label production channel on innovation. A retailer may either choose to integrate backward with a small firm (insourcing) or rely on a national brand manufacturer (outsourcing) to produce its private label. The trade-off between insourcing and outsourcing strategies is a choice between too much or too little innovation (i.e., quality investment) on the private label. When insourcing, an outside-option effect leads the retailer to overinvest to increase its buyer power. When outsourcing, a hold-up effect leads to underinvestment. In addition, selecting the national brand manufacturer may create economies of scale that spur innovation.

Entering New Markets in the Presence of Competition: Price Discrimination versus Cannibalization

Ralph Siebert
This study focuses on firms' optimal entry strategies in new markets when products are differentiated in quality. We are interested in investigating how many products of different qualities firms should introduce into an empty market. One profitable strategy is that firms introduce multiple products to proliferate the product space such that entry by competitors is deterred. Our results show that firms' optimal strategy to enter new markets is described by introducing a single product only. Firms differentiate their products not only toward their rivals' products to soften price competition, but also toward their own goods in order to avoid cannibalizing their own (high quality) product demand.

Unbundling Technology Adoption and tfp at the Firm Level: Do Intangibles Matter?

Michele Battisti, Filippo Belloc, and Massimo Del Gatto
We use a panel of European firms to investigate the relationship between intangible assets and productivity. We distinguish between total factor productivity (tfp) and technology adoption, whereas standard estimations consider only a notion of productivity that conflates the two effects. Although we are unable to address simultaneity, we allow for the existence of multiple technologies within sectors through a mixture model approach. We find that intangible assets have nonnegligible effects that both push firms toward better technologies (technology adoption effects) and allow for more efficient exploitation of a given technology (tfp effects).