DOC PREVIEW
Yale ECON 525 - Advanced Macroeconomics I

This preview shows page 1-2-3-4-5-6 out of 18 pages.

Save
View full document
View full document
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience
View full document
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience
View full document
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience
View full document
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience
View full document
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience
View full document
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience
Premium Document
Do you want full access? Go Premium and unlock all 18 pages.
Access to all documents
Download any document
Ad free experience

Unformatted text preview:

Aghion and Bolton, REStud, 92Diamond and Rajan, JPE, 01Aghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01Advanced Macroeconomics IECON 525a - Fall 2009Yale UniversityGuillermo L. Ordo˜nezWeek 3Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01Main ideasIncomplete contracts call for unexpected situations that needdecision to b e taken.Under misalignment of interests be tween E and L, a contingentcontrol allo cation is optimal.Standard debt contract is exactly this,Default. Control go es to L.NO default: Control remains for E.Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01ModelE needs K to start a project. L is deep pockets.E has all bargaining power. Both are risk neutral.476 REVIEW OF ECONOMIC STUDIES promises an expected return to the investor of at least K, she is willing to take the offer.' This defines the investor's individual rationality constraint. The technological characteris- tics of this project are described in the time-line shown in Figure 1. Thus, the returns of the project are stochastic and depend on an action a chosen from the set of feasible actions A, after the realization of a state of nature 0. 0, is the set of possible states of nature. Investment Realization of state of nature, 0, Realization of returns, r K and signal, s. t = 0 t=1 t t=2 action a is taken FIGURE 1 Both the entrepreneur (E) and the investor (I) are risk neutral in income. Their Von-Neumann-Morgenstern utility functions over income and action pairs are denoted by UE(r, a) and UI(r, a) respectively. We suppose that they take the following simple form: UE(r, a) = r+ l(a,O) (1) U1(r, a) = r. (2) The investor is only interested in the monetary returns of the project. The entrepreneur, who thought about the project and took the initiative of setting it up, cares not only about the monetary returns but also about other less tangible things such as reputation, specific human capital, effort, etc. These non-monetary elements in his payoff depend on the choice of action and on the state of nature; they are represented by the function l(a, 0). (Note that l(a, 0) can be positive or negative). We shall refer to them as the private benefits of the entrepreneur since they are not observable or verifiable by third parties. It is clear, given our specification of preferences, that potential conflicts of interest may arise between the entrepreneur and the investor concerning the choice of action. Most of this paper is concerned with the following questions: (i) whether and how the initial contract can be structured in such a way as to bring about a perfect coincidence of objectives between E and I, and (ii) when the initial contract cannot achieve this coincidence of objectives how should control rights be allocated. In practice the difficulty in confronting this problem arises from the inherent incom- pleteness of financial contracts. Most investment projects are sufficiently complex that it is impossible for the contracting parties to specify ex ante an action correspondence a: :0 - A determining which action ought to be taken as a function of the state of nature, 0. Even if such a correspondence a(0) could be specified it may be difficult to enforce ex post. Consequently, the contracting parties must find roundabout ways of implementing the most desired action-schedule, a(0), such as partial or total delegation of decision rights (over the future action choice) to one or the other party together with an appropriate monetary incentive scheme. Following Grossman-Hart (1986) we model contractual incompleteness by assuming that the state of nature 0 is impossible or very costly to describe ex ante, so that the ex ante contract cannot be contingent on 0. Ex post both parties can tell when the state of 1. Throughout the paper we refer to the entrepreneur as he and to the investor as she. Potential misalignment of interestsUE(r, a) = r + l(a, θ)UL(r, a) = rEverybody observes θ, but cannot describe it ex-ante.There is an informative signal s that can be included in the contract.All monetary returns are observable.Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01ModelAssumer ∈ {0, 1}Θ = {θb, θg}A = {ag, ab} such that ag= a∗(θg) and ab= a∗(θb)s = {0, 1} such that Pr (s = 1|θg) > 1/2 and Pr (s = 1|θb) < 1/2Payoffsyij= Pr(r = 1|θ = θi, a = aj)Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01ContractsContracts specifyA compensation for the manager.A control allocation ruleSince θ is observable ex-post, there may be renegotiation.Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01Full control by the entrepreneurEx-post efficient (after renegotiation).If interests are aligned, this is always feasible.If interests are not aligned, the project will be efficient ifcompensating the manager such that he decides the optimal action.However, this payment may violate the investor’s participationconstraint.Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01Full control by the investorEx-post efficient (after renegotiation).If interests are aligned, this is always feasible.If interests are not aligned, the project will be efficient ifcompensating the investor such that he decides the optimal action.However, this payment may violate the entrepreneur’s limitedliability.Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01Contingent controlWhen the entrepreneur’s control is not feasible and the investor’scontrol does not achieve the first best, an intermediate situation withcontrol contingent on s may dominate unilateral control allocations.Standard debt contractControl allocation may be irrelevant if actions are observable anddebt covenants can be made contingent on signals.Guillermo L. Ordo˜nez Advanced Macroeconomics I ECON 525a - Fall 2009 Yale UniversityAghion and Bolton, REStud, 92 Diamond and Rajan, JPE, 01Main


View Full Document

Yale ECON 525 - Advanced Macroeconomics I

Documents in this Course
Load more
Download Advanced Macroeconomics I
Our administrator received your request to download this document. We will send you the file to your email shortly.
Loading Unlocking...
Login

Join to view Advanced Macroeconomics I and access 3M+ class-specific study document.

or
We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view Advanced Macroeconomics I 2 2 and access 3M+ class-specific study document.

or

By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?