financial mechanism and enforceability of international environmental agreements we examine how international coordination among countries generates a trend towards establishing an international institution for the provision of global public goods in the present model the forces creating international agreement are a politician s motive for re election and a financial mechanism for compliance if a politician expects another politician in a neighboring country to signal his good performance to his citizen by participating in the agreement and is aware that his ex post deviation will be deterred by the financial mechanism he too decides to participate in the agreement which then corrects externality problems

screening ethics when honest agents care about fairness we analyze a principal s ability to discriminate between honest and dishonest agents who have private information about the circumstances of the exchange honest agents reveal circumstances truthfully as long as the mechanism is suciently fair the probability that an equilibrium allocation is chosen by an agent who is lying should not be too large without intolerance for lying the agent is given proper incentives if dishonest and zero rent if honest with even a small intolerance for lying the optimal mechanism is discontinuously altered it may still involve ethics screening whereby some allocation chosen by a dishonest agent is never chosen by an honest agent it happens either when the dishonest is overstating circumstances or when the principal is forced to allow for some suboptimal announcements due to an excessive intolerance for lying with limited intolerance for lying ethics screening allows for doing better than in the standard setup where the agent is dishonest with certainty even if honesty is unlikely however if intolerance for lying is too strong the principal cannot improve upon the standard setup

stochastic equilibria existence spanning number and the no expected financial gain from trade hypothesis stochastic equilibria under uncertainty with continuous time security trading and consumption are demonstrated in a general setting a common question is whether the current price of a security is an unbiased predictor of the future price of the security plus intermediate dividends this is the hypothesis of no expected financial gains from trade the relevance of this hypothesis in multi good economies is called into question by the following demonstrated fact for each set of probability assessments there exists a corresponding equilibrium one with the original agents original equilibrium allocations and no expected financial gains from trade under the given probability assessments the spanning number of the economy is defined as the fewest number of security markets required to sustain a complete markets equilibrium in a dynamic sense made precise in the paper the spanning number is linked directly to agent primitives in particular the manner in which new information resolves uncertainty over time the spanning number is shown to be invariant under bounded changes in expectations several examples are given in which the spanning number is finite even though the number of potential states of the world is infinite

optimal collusion with internal contracting abstract in this paper two firms play an infinitely repeated bertrand game and each firm has an agent who produces the firm s output and holds private information about production costs the colluding firms fix prices and allocate market shares based on their agents information we develop a model of collusion in which firms use the presence of agents as a strategic opportunity to restrict their incentives to distort private information we show that such firm behavior may expand the scope of optimal collusion whether market allocation schemes are asymmetric or symmetric

co operation and unilateral commitment in the presence of global environmental problems this paper focuses on the link between group co operation and unilateral commitment of some countries in the presence of global environmental problems we show that in case of a failure of negotiation some countries can decide to commit unilaterally and reduce their emissions we call this behaviour precautionary commitment absence of international agreement does not mean global defection from the environmental issue we also show that the emergence of a non co ordinated global co operation can result from a strategic action from the members of the coalition the insiders of the coalition create an incentive for the non members to reduce without co ordinating their emissions

risk aversion and arbitrage this paper characterizes conditions under which asset returns and consumption are consistent with risk averse preferences it is shown that risk aversion is equivalent to zero arbitrage on a transformation of the payoff space the implicit state prices which are dual to this no arbitrage condition can be interpreted as prices of pure consumption hedges this zero arbitrage restriction implies the usual restrictions associated with nonsatiation the analysis holds in both complete and incomplete market settings through a number of recent papers in financial economics we have come to understand that the absence of arbitrage opportunities is equivalent to the existence of positive implicit state claim prices in addition given a particular allocation of consumption quantities for different states of the world absence of arbitrage is necessary and sufficient for the consumption plan to be a consumer optimum for some monotonic preference ordering the purpose of this paper is to inquire into the additional restrictions on asset returns imposed by requiring that an allocation be a consumer optimum when preferences are concave monotonic von neumann morgenstern vnm stateindependent and defined over a single good we find that a necessary and sufficient condition is that there is absence of arbitrage not only on the original payoff space but also on a simple transformation of the payoff space this transformation has an intuitively appealing form and can be interpreted as a type of risk adjustment perhaps the classic development of the duality between absence of arbitrage and positive implicit state prices is contained in ross 9 working with a finite number of assets and states ross shows that when positive state prices exist and price returns in a manner consistent with the observed market values of the assets arbitrage is precluded when markets are complete the implicit state prices are uniquely determined and it is easy to check if they are positive more generally there will be many vectors of state prices which value assets in a manner consistent with their observed market prices absence of arbitrage opportunities implies that at least one of these is positive analogues of this result have been shown to hold in more general environments by garman 3 ross 10 harrison and kreps 6 and hansen and richard 5 among others several authors have also noted that zero arbitrage restrictions are necessary and sufficient for an arbitrary positive consumption bundle to be a consumer optimum for some set of monotonic preferences kreps 7 provides perhaps the most general discussion of this point both authors from graduate school of industrial administration carnegie mellon university

stochastic dominance and mean variance measures of profit and loss for business planning and investment in this paper we first extend the stochastic dominance sd theory by introducing the first three orders of both ascending sd asd and descending sd dsd to decisions in business planning and investment to risk averse and risk loving decision makers so that they can compare both return and loss we provide investors with more tools for empirical analysis with which they can identify the first order asd and dsd prospects and discern arbitrage opportunities that could increase his her utility as well as wealth and set up a zero dollar portfolio to make huge profit our tools also enable investors and business planners to identify the third order asd and dsd prospects and make better choices to complement the stochastic dominance approach we also introduce an improved mean variance criterion to decisions in business planning or investment on both return and loss for risk averse and riskloving investors we then illustrate the superiority of the present approaches with well known examples in the literature and discuss the relationship between the improved stochastic dominance and mean variance criteria

catching the agent on the wrong foot ex post choice of monitoring abstract in a principal agent model with multiple performance measures we show that the principal benefits by choosing ex post which variables will be monitored if it is too costly for one type of agent to mimic all performance measures expected from another type the principal can hope to catch the agent on the wrong foot if the agent tries to misrepresent his type for cases of small asymmetry of information the principal can implement the first best contract for more serious asymmetries of information the first best is not implementable then the low type may be required to overproduce which is in contrast to the traditional result of second best contracting we also obtain a ranking of monitoring instruments according to the frequency of their use

inflexible rules in incentive problems in practice contracts involve standard terms or rules allowing for variations only under exceptional circumstances we develop a simple model in which optimal contracts display this feature even in the absence of transactions costs rules arise when an agent has countervailing incentives to misrepresent private information these incentives are created by endowing the agent with a critical factor of production ex ante applications in regulatory labor and legal settings

the changing climate of climate change economics climate change economics is now four decades old much of what it has achieved as a field of academic enquiry can be linked back to issues of integrated assessment modelling this paper shows that the standard approach is going through a major change in scope as of the last five years the conventional focus on determining optimal mitigation paths based on modelling the social cost of carbon is being enlarged to embrace promising new waves of research these are 1 the economics of insurance against catastrophic risks 2 the economics of trade and climate and 3 the economics of climate change adaptation the paper helps to bridge the gap between economics and climate policy by showing that the analytical toolkit of climate change economics has shifted towards more realistic representations of climatic policy

reputation for quality and adverse selection abstract we analyze a dynamic market with a seller who can make a one time investment that affects the returns of tradable assets the potential buyers of the assets cannot observe the seller s investment prior to the trade or verify it in any way after the trade the market faces two types of inefficiency the ex ante inefficiency i e the seller s moral hazard problem and the ex post inefficiency i e inefficient ex post allocations due to the adverse selection problem we analyze how the observability of information by future buyers through which the seller builds a reputation affects the two types of inefficiency as well as the interplay between them

cost uncertainty and unilateral abatement unilateral abatement is sometimes advocated in order to set a good example that will make other countries follow the aim of this paper is to investigate whether existence of correlated cost uncertainty provides an incentive for a country to undertake unilateral abatement the theoretical model is driven by two main mechanisms first a learning effect as the follower country might reduce its risk premium as it can observe the cost level in the leader country second there is the public good effect i e the marginal benefit of abatement declines when abatement is a public good and other countries contribute to pollution reductions results shows that unilateral abatement would be efficient in reducing uncertainty about the unit costs of abatement if a country with low cost uncertainty would undertake abatement first while a country with initially high cost uncertainty would follow however countries may prefer to act simultaneously because of the larger uncertainties that are inherent in a sequential game

screening when some agents are nonstrategic does a monopoly need to exclude we characterize the optimal screening mechanism for a monopolist facing consumers with privately known demands some of whom have limited abilities to misrepresent their preferences we show that consumers with better abilities to misrepresent information benefit from the presence of consumers who lack such abilities whenever the fraction of the latter group is positive there is no exclusion the firm supplies a positive quantity of the good to all consumers whose valuations exceed marginal cost of production our analysis is motivated by the evidence indicating that some individuals have limited ability to misrepresent themselves and imitate others

cost padding in regulated monopolies abstract this paper considers the regulated monopoly that pads or falsifies its costs to increase the cost reimbursement it receives from the regulator contrary to the standard literature on cost regulation the firm engages in cost reducing investment before it enters into a regulatory contract this pre contractual investment in cost reduction determines the firm type at the contracting stage the paper derives both the optimum incentive compatible falsification contract and the equilibrium type distribution with the distribution of cost types determined endogenously by the pre contractual investment choice an increase in the cost of falsification has two effects first there is a direct effect that reduces cost padding because it becomes more expensive to do so second there is an indirect effect that increases cost padding because the firm responds by choosing lower investments and lower investments are associated with more cost padding it is demonstrated that the direct effect will dominate and both expected levels of cost padding and expected costs for falsification will be reduced however the indirect effect increases real costs and despite the reduction in cost padding the net effect can reduce welfare it is determined that these conclusions are significantly different from those obtained when the distribution of cost types is exogenously fixed

call options and the risk of underlying securities abstract merton 1973 in his seminal article theory of rational option pricing showed that the rationally determined price of a call option is a non decreasing function of the riskness of its associated common stock in deriving his results merton made restrictive assumptions about the way the market prices payoff distributions and used the rothschild stiglitz 1970 measure to compare the riskiness of securities i show by means of an example that the merton result will not in general be true i then derive a sufficient condition for the option on one stock to have higher market value than the option on another stock when both the stocks have the same price and explain why the merton result is valid in the black scholes environment

a note on optimal procurement contracts with limited direct cost inflation abstract laffont and tirole s using cost observation to regulate firms j polit econ 94 1986 614 641 pioneering analysis identifies the optimal procurement contract when the supplier can readily inflate his innate production cost without detection when the buyer has some ability to limit such cost inflation an alternative contract can outperform the contract identified by laffont and tirole the alternative contract induces substantial pooling discontinuous production costs and effort supply and rent that varies non monotonically with innate cost

non commitment in performance evaluation and the problem of information distortions abstract auditing is modeled in a sequential game without commitment the manager must decide whether and where to audit a worker s output taking into account all interim information he has obtained the worker will work just hard enough and show it to divert the manager from making an audit or cover up withholding information about his work to make an audit more difficult this usually raises the costs of setting work incentives so incentives are softened sometimes drastically moreover when a worker s on the job information is valuable for entrepreneurial decisions work incentives must be softened to improve the internal flow of information

regulating a monopolist with unknown costs we consider the problem of how to regulate a monopolistic firm whose costs are unknown to the regulator the regulator s objective is to maximize a linear social welfare function of the consumers surplus and the firm s profit in the optimal regulatory policy prices and subsidies are designed as functions of the firm s cost report so that expected social welfare is maximized subject to the constraints that the firm has nonnegative profit and has no incentive to misrepresent its costs we explicitly derive the optimal policy and analyze its properties in their classic papers dupuit 2 and hotelling 5 considered pricing policies for a bridge that had a fixed cost of construction and zero marginal cost they demonstrated that the pricing policy that maximizes consumer well being is to set price equal to marginal cost and to provide a subsidy to the supplier equal to the fixed cost so that a firm would be willing to provide the bridge this first best solution is based on a number of informational assumptions first the demand function is assumed to be known to both the regulator and to the firm while the assumption of complete information may be too strong the assumption that information about demand is as available to the regulator as it is to the firm does not seem unnatural a second informational assumption is that the regulator has complete information about the cost of the firm or at least has the same information about cost as does the firm this assumption is unlikely to be met in reality since the firm would be expected to have better information about costs than would the regulator as weitzman has stated an essential feature of the regulatory environment i am trying to describe is uncertainty about the exact specification of each firm s cost function in most cases even the managers and engineers most closely associated with production will be unable to precisely specify beforehand the cheapest way to generate various hypothetical output levels because they are yet removed from the production process the regulators are likely to be vaguer still about a firm s cost function 12 p 684 as this observation suggests it is natural to expect that a firm would have better information regarding its costs than would a regulator the purpose of this paper is to develop an optimal regulatory policy for the case in which the regulator does not know the costs of the firm one strategy that a regulator could use in the absence of full information about costs is to give the firm the title to the total social surplus and to delegate the pricing decision to the firm in pursuing its own interests which would then be to maximize the total social surplus the firm would adopt the same marginal cost pricing strategy that the regulator would have imposed if the regulator had

on countervailing incentives abstract this paper extends and unifies previous work on optimal contracts under countervailing incentives shedding light in particular on the relation between countervailing incentives and pooling inflexible rules our main result is that the nature of the optimal contract depends crucially on whether the agent s utility is quasiconcave or quasiconvex in the private parameter the optimal contract is separated in the former case and it may entail pooling in the latter case journal of economic literature classification number d82

which is a better investment choice in the hong kong residential property market a big or small property the relationship between property size and property investment yield is an interesting issue in the real estate market previous studies usually use the mean variance criterion to compare the return risk profiles of the yields of different property sizes in the united states however this criterion has a few shortcomings this article provides the first attempt to use a stochastic dominance approach to analyse this issue we adopt two powerful stochastic dominance tests to compare the yields of five property size classes in the hong kong residential property market in our study we analyse two possible investment outcomes 1 investors could not rent out their properties and thus they would gain lose from the appreciation depreciation of residential property prices 2 investors could also gain from rental incomes our empirical results provide strong evidence to show that the yields of smaller property classes stochastically dominate the yields of bigger property classes suggesting that buying smal

valuation methods and policy making in environmental economics 1 valuation methods and policy making in environmental economics relevance and scope h folmer e van ierland part i the valuation of public goods 2 non market asset prices a comparison of three valuation approaches r c d arge j f shogren 3 valuing public goods in a risky world an experiment p o johansson 4 recreational values pareto optimality and timber supply p o johansson k g lofgren k g maler 5 estimating social benefits of environmental improvements from reduced acid rain deposition a contingent valuation survey s navrud part ii the valuation of health and life 6 benefits of reduced morbidity from air pollution control a survey m dickie s gerking 7 valuing a public good direct and indirect valuation approaches to the measurement of the benefits from air pollution abatement m shechter m kim l golan 8 environmental regulation and the valuation of life interindustry mobility and the market price of safety h w herzog jr a m schlottmann part iii cost benefit analysis 9 disequilibrium cost benefit rules an exposition and extension p o johansson k g lofgren 10 macroeconomic cost benefit analysis of environmental programmes a nentjes part iv aspects of policy making 11 benefit estimation for complex policies a randall j hoehn 12 the acid rain game k g maler index

noisy observation in adverse selection models we consider a principal agent contracting problem under incomplete information where some of the agent s actions are imperfectly observable contracts take the form of reward schedules based on the noisy observation of the agent s action we first review situations where the principal can reach the same utility as in the absence of noise then we focus on the use of linear reward schedules which allow universal implementation i e implementation of a given mechanism for any unbiased noise of observation and on quadratic reward schedules which only require the knowledge of the variance of the noise we exhibit sufficient conditions under which linear reward schedules implement a given mechanism finally we characterize necessary conditions for a mechanism to be implementable under noisy observation by a linear schedule and by quadratic schedules we give the geometric intuition behind all results

costly distortion of information in agency problems anecdotal evidence suggests that agents often spend resources distorting information transmitted to principals we present a model where costly information distortion emerges as equilibrium behavior the information structure we focus on is intermediate between and encompasses the cases of private information and public information the agent can falsify the privately observed state at some cost although the principal can design contracts that induce no falsification these may involve excessive iinformation rents falsification can be beneficial in spite of the waste of resources involved because it helps reduce information rents we examine how optimal contract and equilibrium payoffs change as the information structure ranges from private to public information

stochastic dominance pareto optimality and equilibrium asset pricing pricing a factor subspace contains the market portfolio and is such that every marketed contingent claim is second order stochastically dominated by a claim from the factor subspace conditions are given for the existence of equilibrium and it is shown how apt and capm can be interpreted in the framework of the paper if sufficiently many call options on the market portfolio are traded then the space spanned by these options can be used as the factor subspace we consider markets in which a collection of financial assets are traded the collection may be finite or infinite markets are frictionless and short sales of assets are permitted asset payoffs are random variables which are elements of a space of contingent claims by forming portfolios of the marketed assets payoffs in a certain linear subspace of the space of all contingent claims can be attained we call this subspace a space of marketed claims we say that a closed subspace of the space of marketed claims is a factor subspace if two conditions are satisfied first the market portfolio payoff i e the payoff of an aggregate endowment of portfolios per capita belongs to this subspace second every marketed contingent claim is dominated in the sense of second order stochastic dominance by some contingent claim in the factor subspace we demonstrate that for each asset market economy there is a well defined minimal factor subspace in the sense that no proper subspace of it can be a factor subspace if markets are complete i e if a full set of arrow securities are traded then the price of any given asset can be expressed in terms of prices of arrow securities or state prices breeden and litzenberger 1978 have shown that state prices can be replaced by the values of options thus in a complete market asset prices are determined either by state prices or call options it is established in this paper that these ideas and methods are applicable to asset pricing theories even when markets are incomplete making use of the argument of second order stochastic dominance we show that every constrained pareto optimal portfolio allocation consists exclusively of portfolios which generate the factor subspace the same holds for an equilibrium portfolio allocation thus for an economy with a factor subspace only a partial set of arrow securities which is large enough to generate the factor subspace is required to price assets this paper establishes that there exists an equilibrium in which the price of a portfolio equals the price of the dominating portfolio with the same expected return in the factor subspace since the dominating

informational benefits of international treaties international treaties allow a minister in one country to learn about the beliefs held by a minister in another country so allowing each to make better decisions when the net benefits of environmental policy are uncertain a country which participates in negotiating an environmental treaty or which supports strong environmental action thereby provides information to another country that such action can be worthwhile this dimension of international environmental agreements helps explain why countries negotiate treaties why these treaties often implement the nash non cooperative equilibrium why agreement to a treaty by a country deemed not particularly favorable to it can strengthen environmental action and why treaties may invoke a minimum participation clause the informational mechanism we discuss holds even if physical spillovers are absent and even if monitoring and enforcement are infeasible our approach can explain additional phenomena how requirements for approval by several bodies within a country can increase support for a policy and why simultaneous action can lead to better outcomes than sequential action

the relationship between arbitrage and first order stochastic dominance this paper joins together two fields of research in financial economics the first field studies stochastic dominance while the second field studies arbitrage pricing the two fields are linked together through the derivation and the proof of a characterization theorem the characterization theorem gives necessary and sufficient conditions for the existence of arbitrage opportunities in terms of the existence of two assets one of which first order stochastically dominates the other and the price of a particular contingent claim examples are provided to demonstrate the theorem s content this paper joins together two fields of research in financial economics the first field studies portfolio choice from the perspective of stochastic dominance see hadar and russell 5 6 hanoch and levy 7 levy and kroll 13 the second field studies arbitrage pricing its characterization and implications see ross 15 kreps 12 harrison and kreps 8 harrison and pliska 9 in these fields it is well known that the existence of arbitrage opportunities implies first order stochastic dominance and that the converse does not hold this paper provides a set of conditions under which the converse is true given complete markets the existence of an arbitrage opportunity is characterized in terms of the existence of two traded assets one of which stochastically dominates the other along with one additional condition the additional condition is roughly that state contingent prices must be zero over the states where the first asset dominates the second the theorem has a qualification however it is applicable only in markets which are complete not in the arrow debreu sense but in a weaker sense in the sense that all contingent claims on the primary assets must trade in many applications especially with respect to continuous trading models this condition is usually satisfied see duffie 2 and harrison and pliska 9 in the case of stochastically dominated assets this paper shows that the relationship of the assets to the state contingent prices is important in identifying arbitrage opportunities in this sense this paper is related to a recent paper of jagannathan 10 jagannathan studies the relationship of second order stochastic dominance not first order to call option valuation this characterization theorem relating arbitrage opportunities to stochastic dominance should provide a valuable tool in the area of stochastic dominance this theorem specifies conditions under which two assets can be compared using first order stochastic dominance on an individual basis for inclusion in the

optimal insurance under costly falsification and costly inexact verification abstract this paper integrates the often dichotomized models of costly state verification and costly claim falsification it is found that when verification is inexact it is possible for an optimal insurance contract to consist of both positive claim falsification and positive insurer verification provided that falsification cost and verification cost are sufficiently low and the insured is risk averse satisfying constant absolute risk aversion this result certainly contrasts with the common belief that falsification and verification are mutually exclusive in an optimal insurance contract some characteristics of the optimal falsification verification and indemnification profiles including implementability are analyzed

could the global financial crisis improve the performance of the g7 stocks markets abstractfinancial crises are normally associated with negative effects on financial markets in this article we investigate whether the most recent global financial crisis gfc had any positive impact on the g7 canada france germany italy japan the united kingdom and the united states indices to conduct the analysis we employ the mean variance mv analysis capm statistics hurst exponent runs test multiple variation ratio test and stochastic dominance sd tests our mv and capm results conclude that most of the g7 stock indices are significantly less volatile the results from hurst exponent run tests and multiple variation ratio confirm that efficiency improved in the post gfc period finally our sd results conclude that there is no arbitrage opportunity and the markets are efficient due to the gfc and in general investors prefer investing in the indices after the gfc overall we conclude that the gfc led to markets that are more efficient and mature confirming that crises can also

on the merit of equal pay performance manipulation and incentive setting abstract work performance is often difficult to assess thus leaving room for manipulation of commonly used metrics we created a laboratory workplace in which we can precisely assess both work performance along with manipulation activities using two independent experiments we show that whenever pay for performance is used manipulation is pervasive leading to both a waste of organizational resources and a weakening of incentives by contrast paying organizational members equally effectively deters manipulation attempts leading to higher organizational production

regulation asymmetric information and auditing this article analyzes a model of a regulated firm that is better informed about its cost function than is the regulator by auditing at a cost however the regulator is assumed to be able to observe the realized cost of the firm if the regulator finds that the firm had misrepresented its costs at the time at which prices were set he can order a refund to consumers in the optimal policy the regulator audits when the firm reports for pricing purposes that its costs will be high and orders a refund when the auditfinds that realized costs are lower than anticipated given the original report a separation result that obtains for an important case indicates that the initial pricing decision is independent of the auditing decision the auditing decision however depends on the price that was initially set the optimal auditing strategy is characterized and the nature of the welfare gains are identified the methodology used in the analysis involves the characterization of an equilibrium of a revelation game with an ex post observable

managers compensation and misreporting a costly state verification approach i introduction the use of stock options in compensation packages as a way of providing the firm management with the right incentives has been quite popular in the 1990s the favor encountered by options started however to decrease in the past few years the decline in the use of option grants in top executives compensation packages occurred mainly as a reaction to the recent accounting scandals which has prompted the design of alternative stock based compensation schemes e g restricted stock grants or indexed options as reported by hall and murphy 2003 the grant date value of options assigned to all employees of an average standard poor s 500 firm measured in millions of 2002 constant us increased from 22 in 1992 to 238 in 2000 and subsequently decreased to 141 in 2002 although percentages varied from year to year the ceos share of the total grant has fallen from about 7 in the mid 1990s to less than 5 in 2000 2002 1 the decline in the use of options for top management is widely confirmed according to a pearl meyer partners study for the new york times stock option grants that accounted for 52 of the pay of the average ceo of a major company in 2002 were down to an estimated 35 in 2003 a recent watson wyatt report states that the value of new stock option awards granted to ceos at large companies fell by nearly 60 between 2001 and 2003 with the average value of new stock option grants declining from us 10 2 million in 2001 to us 4 2 million in 2003 the decline in options has been softened by the sharp increase in restricted stock grants and other long term incentive award values 2 in this paper we aim to reevaluate the role of stock options as an ingredient of top management compensation packages able to align the interests of managers and shareholders avoiding misreporting of the firm value at the same time 3 in a costly state verification csv model with moral hazard we show that incentive compatible contracts inducing both incentive alignment and truthful revelation of the firm value must entail a strictly convex compensation schedule that is a fixed payment wage when the firm value is sufficiently low and a state contingent claim increasing in the firm value otherwise a simple and commonly observed way to achieve a convex compensation scheme is to design a remuneration including a fixed wage and a call option on the firm equity as we will show such remuneration allows on the one hand to preserve top management incentives providing for a compensation increasing in equity value and on the other hand to reduce the verification costs that must be incurred to avoid misreporting as verification is not needed in the region where the remuneration is fixed 4 options are by no means the only way to achieve a convex compensation however many other schemes having otherwise desirable properties over options do not have the convex shape discussed above for instance combining a fixed wage with restricted stock grants defines a compensation linearly increasing in the firm s equity value which does not allow to reduce misreporting verification costs that always have to be sustained in this case using an incentive compatible compensation scheme fixed wage plus call options we characterize the contract offered by the firm under the assumption of a deterministic and perfect audit technology showing that for any given value of the option package the manager should receive the largest possible number of options at the highest strike price allowing shareholders to reduce the expected verification cost furthermore the strike price of the option turns out to be determined by incentive compatibility i e the option value must be such that the manager is induced to exert the desired level of effort while the magnitude of the fixed wage is defined by individual rationality there are three main policy implications of our analysis

optimal regulation of eutrophying lakes fjords and rivers in the presence of threshold effects eutrophication is a biological process that has an unfavorable economic impact on the economic value of the water basins it affects eutrophication depends on thresholds effects and optimal policies for the regulation of eutrophication must take this into account such optimal policies are derived in the present article by utilizing a novel technique in optimal control theory this technique facilitates a proper analysis of deterministic stock pollutants with thresholds effects a topic it is argued has been poorly understood in the literature copyright 2001 oxford university press

identifying and testing models of managerial compensation this article analyses the identification and empirical content of the pure moral hazard pmh and the hybrid moral hazard hmh principal agent models the pmh model has hidden actions while the hmh model has hidden information in addition to hidden actions in both models agents are risk averse and principals are risk neutral the article derives the equilibrium restrictions from the optimal contract and uses the restrictions to show that the models have empirical content for any given risk aversion parameter the models other parameters are non parametrically point identified the risk aversion parameter and hence the model are however only partially identified management s ability to manipulate accounting reports arises endogenously within hmh models but not in all versions of pmh models we use our framework to investigate whether shareholders contract with management recognizing that accounting reports are susceptible to manipulation and therefore endogenous to the incentives offered to management the data reject all models in which accounting reports are verifiable furthermore the version of the pmh in which accounting reports can be manipulated is rejected if expected compensation is restricted to be positive

stochastic dominance and expected utility survey and analysis while stochastic dominance has been employed in various forms as early as 1932 it has only been since 1969 1970 that the notion has been developed and extensively employed in the area of economics finance agriculture statistics marketing and operations research in this survey the first second and third order stochastic dominance rules are discussed with an emphasis on the development in the area since the 1980s

climate policy negotiations with incomplete information we analyse bargaining over international climate agreements in a setting with incomplete information about abatement costs incomplete information is known as one of the key reasons why negotiations may fail more generally and why efficiency gains cannot be exploited we ask whether unilateral commitment to high abatement reduces or increases the likelihood for an efficient negotiation outcome we find that such commitment behaviour reduces the gains from global cooperation and that in turn this reduces the probability of reaching efficient international environmental agreements

using cost observation to regulate firms the paper emphasizes the use of accounting data in regulatory or procurement contracts when the supplier 1 has superior information about the cost of the project and 2 invests in cost reduction the main result states that under risk neutrality the supplier announces an expected cost and is given an incentive contract linear in cost overruns this optimal contract moves toward a fixed price contract as the announced cost decreases an investment choice is then introduced and the use of a rate of return regulation is studied

ceo replacement under private information this article examines the optimal ceo compensation and replacement policy when the ceo is privately informed about the firm s continuation value under his leadership ex ante moral hazard implies that the ceo must receive ex post quasi rents which endogenously biases him toward continuation our model shows that to induce bad ceos to quit it may be best to make continuation costly through steep incentive pay rather than simply rewarding quitting through severance pay incentive pay makes continuation attractive for good ceos who can expect high future on the job pay but unattractive for bad ceos who may instead prefer to take their outside option payoff our model generates novel empirical implications that jointly relate ceo compensation and turnover to corporate governance firm size cash flow risk and the informativeness of performance measurement jel g34

a complete solution to a class of principal agent problems with an application to the control of a self managed firm this paper considers a class of principal agent problems which have the following features 1 there is adverse selection because the principal ignores the value of one parameter of the agent s true characteristics 2 leaving aside the information parameter the principal s welfare as well as the agent s welfare depend on two types of variables observable to both of them the first ones possibly multidimensional are called action variable s and the second one which is one dimensional has in general the meaning of a money transfer 3 the principal is a stackelberg leader of the two person game he can commit himself to decision rules which are admissible on informational grounds he optimizes within the adequate class taking into account besides the agent s reaction one constraint which has generally the meaning of an individual rationality constraint and sometimes of a feasibility constraint the optimization is limited to the class of non stochastic mechanisms 4 the problem can also receive an alternative interpretation the principal faces a continuum of agents of unknown characteristics the distribution being known however stylized principal agent problems of this type have often been considered in the economic literature in particular the reader will later be able to recognize that the standard income tax model a la mirrlees 1971 the quality or quantity choice model of the monopolist a la mussa and rosen 1978 or maskin and riley 1982 and the model of government regulation of the private monopolist of baron and myerson 1982 all belong to

costly verification of cost performance and the competition for incentive contracts this article analyzes the optimal linear incentive contract to offer to would be agents competing for a principal s project when the principal finds it costly to observe an agent s cost performance ex post and cannot commit to monitoring policy ex ante cost sharing reduces the winning bidder s informational rents but creates an incentive for the agent to pad costs ex post to slacken his effort the optimal cost sharing parameter generally differs from that when monitoring is costless and it is higher the fewer the number of bidders and the larger the variance of their idiosyncratic cost

competition for talent under performance manipulation abstract we study the effects of introducing competition for ceos assuming that the talent of ceos is not observable and that they can misreport their performance without competition for talent firms maximize their profits by offering inefficiently low powered incentive contracts competition for talent removes those inefficiencies but it leads to excessively high powered incentive contracts causing efficiency losses that can be more severe than the inefficiencies that competition mitigates if misreporting is not a concern however then competition for talent has unambiguously positive effects on efficiency

stochastic dominance via quantile regression with applications to investigate arbitrage opportunity and market efficiency abstract tests for stochastic dominance constructed by translating the inference problem of stochastic dominance into parameter restrictions in quantile regressions are proposed they are variants of the one sided kolmogorov smirnoff statistic with a limiting distribution of the standard brownian bridge the procedure to obtain the critical values of our proposed test statistics are provided simulation results show their superior size and power they are applied to the nasdaq 100 and s p 500 indices to investigate dominance relationship before and after major turning points results show no arbitrage opportunity between the bear and bull markets our results infer that markets are inefficient and risk averters are better off investing in the bull rather than the bear market

optimal contracts under costly state falsification we examine an exchange economy with two agents one risk neutral with a certain endowment and a second risk averse with a random endowment the realization of the endowment is public but can be falsified by the second agent at a cost for a broad class of falsification cost functions the optimal no falsification contract is noncontingent on a left hand interval and strictly increasing with a slope strictly less than one on a right hand interval under a mild further restriction optimal no falsification contracts are in addition piece wise linear optimal contracts may in general require falsifying the state but for a set of the highest endowment realizations there is no falsification we find simple conditions under which the optimal contract is a no falsification contract the model has applications that include financial insurance and employment contracts and tax policy

partially verifiable information and mechanism design in a principal agent model with adverse selection we study the implementation of social choice functions when the agent s message space is a correspondence which depends on this true characteristic we characterize such correspondence for which the revelation principle is valid returns must not contradict easily observable elements of the taxpayer s lifestyle in this paper we present a model of two person organizations in which these considerations are important we ask whether the restrictions on fallacious statements inherent in the system are sufficient to achieve the goals of the organization we show that the optimal way of eliciting the agent s response may not be to establish incentives for truthtelling in all instances in our model there is one player the agent who observes the state of the economic system another player the principal takes an action based on the information presented to him by the agent this class of models is often referred to as the principal agent problem in the extensive and growing literature on this problem it has always been assumed that the agent could lie to the principal and therefore that he had to be properly motivated to act at least partially in the principal s interest our formal way of modelling the partial verifiability of information is to introduce the restriction that the agent s responses must lie in a set m o that varies with the true state 0 it is assumed that this set always admits the possibility of responding with the true state the way in which the allowable response set varies with the true state is known to the principal in other respects we retain the usual principal agent formalization in particular the principal is the stackelberg leader in this game he can commit himself to choose a collective action as a function of the message transmitted by the agent whether the variation of the message space with the true observation is purely technological or whether it is induced by the severity of potential actions of the principal

are you a good employee or simply a good guy influence costs and contract design we develop a principal agent model with a moral hazard problem in which the principal has access to a hard signal the level of output and a soft behavioral signal the supervision signal about the agent s level of effort in our model the agent can initiate influence activities and manipulate the behavioral signal these activities are costly for the principal as they detract the agent from the productive task we show that the agent s ability to manipulate the behavioral signal leads to low powered incentives and increases the cost of implementing the efficient equilibrium as a result interestingly the fact that manipulation activities entail productivity losses may lead to the design of influence free contracts that deter manipulation and lead to high powered incentives this result implies that the optimal contract and whether manipulation is tolerated in equilibrium or not depends on the magnitude of the productivity based influence costs we show that it may be optimal for the principal not to supervise the agent even if the cost of supervision is arbitrarily low

the effect of earnings forecasts on earnings management we develop a theory of the association between earnings management and voluntary management forecasts in an agency setting earnings management is modeled as a window dressing action that can increase the firm s reported accounting earnings but has no impact on the firm s real cash flows earnings forecasts are modeled as the manager s communication of the firm s future cash flows we show that it is easier to prevent the manager from managing earnings if he is asked to forecast earnings we also show that earnings management is more likely to follow high earnings forecasts than low earnings forecasts finally our analysis shows that shareholders may not find it optimal to prohibit earnings management earlier results rationalize earnings management by violating some assumption underlying the revelation principle by contrast in our model the principal can make full commitments and communication is unrestricted nonetheless earnings management can be beneficial as it reduces the cost of eliciting truthful forecasts

endogenous punishments in agency with verifiable ex post information the article studies an adverse selection model in which a contractible imperfect signal on the agent s type is revealed ex post the agent is wealth constrained which implies that the maximum penalty depends on the contracted transaction e g the volume of trade first we show that the qualitative effects of the signal can be unambiguously tied to the nature of the problem e g whether the agent is in a buyer or a seller position second the distortions caused by informational asymmetries may become more severe although more information is now available finally the signal can actually serve to increase the agent s informational rents

theories of risk testing investor behaviour on the taiwan stock and stock index futures markets investor behavior towards risk lies at the heart of economic decision making in general and modern investment theory and practice in particular this paper uses both the mean variance mv criterion and stochastic dominance sd procedures to analyze the preferences for four of the most widely studied investor types in the taiwan stock and stock index futures market we find that risk averters concave utility function prefer spot to futures whereas risk seekers convex utility function prefer futures to spot our findings also show that investors with s shaped utility functions prefer spot futures to futures spot when markets move upward downward finally our results imply that investors with reverse s shaped utility functions prefer futures spot to spot futures when markets move upward downward these results are robust with respect to sub periods spot returns including dividends and diversification although we do not check whether risk averters risk seekers and investors with s shaped and reverse sshaped utility functions actually exist in the market we do show that their existence is plausible the implications of our findings on market efficiency and the existence of arbitrage opportunities are also discussed in this study

countervailing incentives in agency problems abstract we analyze countervailing incentives in agency problem countervailing incentives exist when the agent has an incentive to understate his private information for some of its realizations and to overstate it for others when countervailing incentives arise pooling generally characterizes the equilibrium contract furthermore performance is distorted both above and below efficient levels in addition the agent s rents generally increase with the realization of his private information over some ranges and decrease over other ranges we demonstate that the creation of countervailing incentives can enhance aggregate welfare

spanning and completeness in markets with contingent claims abstract we characterize financial markets that are complete or that contain portfolios which span all measurable functions of a particular asset payoffs either finite and infinite dimensional these results are then employed to describe the extent to which options trading is sufficient to complete markets to investigate the existence of efficient funds and to establish the extent of market completeness required to ensure the unanimity and irrelevance results of modern corporation finance

the classical soviet type economy nature of the system and implications for reform i t is increasingly apparent that the traditional soviet type command economy is a catastrophic failure despite the touted statistical gains of real socialism during the last 40 years we now understand that these gains were largely a statistical illusion fostered by mismeasurement faulty methodology systemic incentives for exaggeration and ideologically and politically motivated distortion winiecki 1988 ericson 1990 moreover the economic system of real socialism in each of these states has imposed large negative social political ecological and personal externalities significant economic reform is now generally accepted as an imperative i am however convinced that successful economic reform of the soviet type economy will require a more comprehensive attack than hitherto attempted to understand the immense difficulties facing radical reform in the soviet union and eastern europe one needs to perceive the soviet type economy as a coherent whole a true system with its own inherent logic necessary components and natural interaction of those components it like any other economic system is as much an organism as a mechanism tending to counteract forces impinging frorn outside and to equilibrate the natural forces and tendencies that arise within it the logic and natural equilibrium of a command economy differ qualitatively and significantly from that of a largely private enterprise market economy hence reforms of a soviet type economy that are consistent with the basic nature of the system survive without altering the qualitative characteristics of

efficient moral hazard abstract this paper presents an infinite horizon discounted dynamic programming model of the endogenous opportunity costs of an agent s effort that is allocated among an endogenous number of principals an agent allocates effort between evaluating new principals and attending to current principals since each principal s return is not maximized by the agent s optimal allocation moral hazard occurs in equilibrium however since the agent maximizes the total expected value of all undertaken projects the agent s allocation of effort is efficient if the agent chooses a single principal then moral hazard does not occur and the allocation is efficient these results are contrary to the inefficient moral hazard results in bilateral principal agent p a and common agency c a models

mechanism design with weaker incentive compatibility constraints abstract we study an adverse selection problem where an agent is able to understate his productivity but not allowed to overstate it the solution to this problem is generally different than the solution to the standard problem where no restriction is made on the statements of the agent we identify a sufficient condition that does not depend on the distribution of types under which these two solutions coincide

stochastic dominance and expected utility while stochastic dominance has been employed in various forms as early as 1932 it has only been since 1969 1970 that the notion has been developed and extensively employed in the area of economics

option pricing and implicit volatilities abstract this paper demonstrates that black scholes implied volatilities can be used to value options in many situations where the assumptions of the black scholes model are violated including i alternative stock processes ii stochastic interest rates and iii market frictions given its computational simplicity this procedure provides an attractive alternative to the more complex models with a direct estimation procedure

market efficiency of oil spot and futures a mean variance and stochastic dominance approach this paper examines the market efficiency of oil spot and futures prices by using both mean variance mv and stochastic dominance sd approaches based on the west texas intermediate crude oil data for the sample period 1989 2008 we find no evidence of any mv and sd relationships between oil spot and futures indices this infers that there is no arbitrage opportunity between these two markets spot and futures do not dominate one another investors are indifferent to investing spot or futures and the spot and futures oil markets are efficient and rational the empirical findings are robust to each sub period before and after the crises for different crises and also to portfolio diversification

strategic communication with lying costs i study a model of strategic communication between an uninformed receiver and an informed but upwardly biased sender the sender bears a cost of lying or more broadly of misrepresenting his private information the main results show that inflated language naturally arises in this environment where the sender almost always claims to be of a higher type than he would with complete information regardless of the intensity of lying cost there is incomplete separation with some pooling on the highest messages the degree of language inflation and how much information is revealed depend upon the intensity of lying cost the analysis delivers a framework to span a class of cheap talk and verifiable disclosure games unifying the polar predictions they make under large conflicts of interest i use the model to discuss how the degree of manipulability of information can affect the trade off between delegation and communication copyright 2009 wiley blackwell

is honesty the best policy curtailing insurance fraud through optimal incentive contracts an incentive contracting approach is used to characterize optimal contracts when insured individuals possess private information about their losses and are able to misrepresent permanently their loss magnitudes by engaging in the falsification of claims we demonstrate that efficient agreements necessarily induce some falsification but that the extent of such claims inflation is mitigated partially by an indemnification schedule that overcompensates small losses while overpaying larger ones the differential costs of generating insurance claims through falsification provide an avenue by which the heterogencous insureds can credibly signal their underlying losses and are exploited in an optimal contract to implement loss contingent insurance payments