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Working Paper
Optimal Contracts with Reflection
In this paper, we show that whenever the agent's outside option is nonzero, the optimal contract in the continuous-time principal-agent model of Sannikov (2008) is reflective at the lower bound. This means the agent is never terminated or retired after poor performance. Instead, the agent is asked to put zero effort temporarily, which brings his continuation value up. The agent is then asked to resume effort, and the contract continues. We show that a nonzero agent's outside option arises endogenously if the agent is allowed to quit and find a new firm (after a random search time of finite ...
Working Paper
Optimal personal bankruptcy design : A Mirrlees approach
In this paper, we develop a normative theory of unsecured consumer credit and personal bankruptcy based on the optimal trade-off between incentives and insurance. First, in order to characterize this trade-off, we solve a dynamic moral hazard problem in which agents' private effort decisions influence the life-cycle profiles of their earnings. We then show how the optimal allocation of individual effort and consumption can be implemented in a market equilibrium in which (i) agents and intermediaries repeatedly trade in secured and unsecured debt instruments, and (ii) agents obtain ...
Journal Article
Optimal Institutions in Economies with Private Information: Exclusive Contracts, Taxes, and Bankruptcy Law
In economies with private information, it is typically optimal to prohibit or otherwise discourage a subset of trades that individual agents want to enter. Economists often refer to such optimal distortions as wedges. In this article, we use a simple private-information Mirrleesian economy to, first, show examples of these wedges and, second, discuss institutions that may be used to implement them in practice. We discuss and compare three such institutions: exclusive contracts, taxes, and bankruptcy law. Our analysis underscores the multiplicity of possible implementations and, therefore, the ...
Working Paper
Market-based incentives
We study optimal incentives in a principal-agent problem in which the agent's outside option is determined endogenously in a competitive labor market. In equilibrium, strong performance increases the agent's market value. When this value becomes sufficiently high, the threat of the agent's quitting forces the principal to give the agent a raise. The prospect of obtaining this raise gives the agent an incentive to exert effort, which reduces the need for standard incentives, like bonuses. In fact, whenever the agent's option to quit is close to being "in the money," the market-induced ...
Journal Article
Pecuniary Externalities, Segregated Exchanges, and Market Liquidity in a Diamond-Dybvig Economy with Retrade
Pecuniary externalities often serve as a rationale for government intervention into financial markets. This article reviews the theory of market provision of liquidity in a Diamond-Dybvig economy and examines whether or not the possibility of retrade leads to pecuniary externalities and market failure. The answer hinges on the credibility of market participants' commitment to not enter into hidden transactions with non-participants. If such commitment is not credible, then unrestricted, hidden retrade leads to a pecuniary externality and market under-provision of liquidity. If such commitment ...
Briefing
How Exclusive Homebuyer Representation Contracts Help Keep Commissions High
Real estate agents use exclusive buyer representation contracts to capture homebuyers and thus limit outside options of home sellers.With outside options severely limited, home sellers pay high commissions (up to 6 percent) to sell their homes on the platform of real estate agents.A ban on exclusive buyer representation contracts is strongly pro-competitive: It improves the sellers' outside options and forces the platform to reduce real estate commissions to constrained-efficient levels.
Journal Article
Saving for Retirement with Job Loss Risk
This article studies a tractable theoretical model of optimal consumption and saving decisions with endogenous retirement. Particular attention is paid to the impact of an increase in the risk of losing one?s job on the optimal path of consumption and wealth accumulation. Even if one does not actually lose their job, an increase in the risk of a job loss is by itself sufficient to cause lower consumption, higher saving, and, through faster retirement, lower labor supply.
Journal Article
Distortionary taxation for efficient redistribution
This article uses a simple model to review the economic theory of efficient redistributive taxation. The model economy is a Lucas-tree economy, in which income comes from a stock of productive capital. Agents, who own the capital stock, are heterogenous with respect to their preference for early versus late consumption. A competitive capital market, in equilibrium, supports a unique Pareto-efficient allocation of consumption among the agents, i.e., the First Welfare Theorem holds. The equilibrium allocation represents one efficient division of the total gains from trade that are available in ...
Working Paper
Risky human capital and deferred capital income taxation
We study the structure of optimal wedges and capital taxes in a Mirrlees economy with endogenous skills. Human capital is a private state variable that drives the skill process of each individual. Building on the findings of the labor literature, we assume that human capital investment is a) risky, b) made early in the life-cycle, and c) hard to distinguish from consumption. These assumptions lead to the optimality of a) a human capital premium, i.e., an excess return on human capital relative to physical capital, b) a large intertemporal wedge early in the life-cycle stemming from the lack ...
Briefing
The Differing Effects of the Business Cycle on Small and Large Banks
Small banks and large banks respond differently to business cycle fluctuations. The average net interest margin (NIM) at large banks is negatively correlated with the business cycle, while the average NIM at small banks is positively correlated with the business cycle. In a popular view, small banks are different from large banks because of their close relationships with their borrowers. But a decomposition of the cyclical properties of NIM into the asset and liability sides of the balance sheet suggests that small banks' procyclical NIM is due to their ability to keep funding costs less ...