Essays on Contract Theory

Brasiliense de Castro Pires, Henrique

doi:https://doi.org/10.21985/n2-q830-pk25

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Essays on Contract Theory

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This dissertation consists of three chapters on contract theory. In Chapter 1, ``Agency in Hierarchies: Middle Managers and Performance Evaluations'', I study the optimal joint design of incentives and performance rating scales in a principal-manager-worker hierarchy. The principal wants to motivate the manager and the worker to exert unobservable effort. Given effort choices, two signals are realized: public and verifiable team output and a non-verifiable signal about the worker's effort, privately observed by the manager. The principal may try to elicit the manager's private information by requiring her to evaluate the worker's performance. Payments depend on team output and the manager's evaluation. I show that the principal can achieve no more than what is feasible with a binary rating scale. Also, subjective performance evaluations are valuable if and only if the verifiable performance measure is more informative than the non-verifiable one. Finally, I show that the principal may benefit from reducing transparency in the organization, as the cost of implementing the desired efforts can strictly decrease when the manager has less information about the worker's effort. In Chapter 2, ``Monitoring, Disclosure, and Retaliation'', I analyze the effects of retaliation on optimal contracts in a hierarchy consisting of a principal, a monitor, and an agent. With probability m, the monitor observes a signal about the agent's effort and decides whether to reveal it to the principal. With probability (1-m), the monitor is uninformed. The agent retaliates against the monitor and the principal whenever the disclosed signal reduces his compensation from the no disclosure benchmark. I show that the principal's optimal contracting problem can be divided into two steps: first an information acquisition stage. The principal chooses how much retaliation to tolerate, and more retaliation generates signals that are more informative (in the Blackwell sense) about the agent's effort. Second, given the information acquired, the principal designs the optimal payment schemes, which pool moderately (potentially all) bad agent's performances with the uninformative signal realization. The empirical literature documents that performance evaluations are lenient, and supervisors are reluctant to provide poor ratings. I show that this pattern can stem from retaliation concerns. Chapter 3, ``The Effect of Exit Rights on Cost-based Procurement Contracts'' (joint work with Rodrigo Andrade and Humberto Moreira) studies procurement contracts in an environment with dynamic arrival of information and ex-post exit rights. A procuring agency designs contracts for a firm that receives information over time. In the first period, the firm receives a private non-fully informative signal about the project's cost. In the second period, the firm fully learns the cost and decides whether to keep the contract or take an exogenous ex-post outside option. When the ex-post outside option is sufficiently close to the ex-ante outside option, the optimal mechanism takes a static form: it pools all first-period signal reports into a single contract, and payments depend solely on the second-period reports. The interpretation is that optimal contracts do not condition transfers on ex-ante cost estimates but only on realized costs. Finally, we show that if the procuring agency neglects the firm's ex-post participation constraint, the firm has the incentive first to underreport expected costs and then take the ex-post outside option if the realized costs are high. This observation is consistent with the ubiquitous cost-overruns observed empirically in procurement projects.

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