Contractual externalities and systemic risk

Ozdenoren, E and Yuan, K (2017) Contractual externalities and systemic risk. The Review of Economic Studies, 84 (4). pp. 1789-1817. ISSN 1467-937X OPEN ACCESS

Abstract

We study effort and risk-taking behaviour in an economy with a continuum of principal-agent pairs where each agent exerts costly hidden effort. Principals write contracts based on both absolute and relative performance evaluations (APE and RPE) to make individually optimal risk-return trade-offs but do not take into account their impact on endogenously determined aggregate variables. This results in contractual externalities when these aggregate variables are used as benchmarks in contracts. Contractual externalities have welfare changing effects when principals put too much weight on APE or RPE due to information frictions. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivise their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks. The opposite occurs when the expected productivity is low, inducing pro-cyclical investment and risk-taking behaviours.

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Item Type: Article
Subject Areas: Economics
Additional Information: © 2016 Review of Economic Studies Ltd. This is a pre-copyedited, author-produced version of an article accepted for publication in The Review of Economic Studies following peer review. The version of record: Emre Ozdenoren, Kathy Yuan (2017); Contractual Externalities and Systemic Risk, The Review of Economic Studies, Volume 84, Issue 4, 1 October 2017, Pages 1789–1817 is available online at: https://academic.oup.com/restud/article/84/4/1789/2823691 and at: https://doi.org/10.1093/restud/rdw058
Subjects: C > Contracts and agency
R > Risk
Date Deposited: 01 Nov 2016 18:44
Last Modified: 22 Sep 2019 12:53
URI: http://lbsresearch.london.edu/id/eprint/570
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