Studies in the dynamics of contracts and markets

Toxvaerd, F (2002) Studies in the dynamics of contracts and markets. Doctoral thesis, University of London: London Business School.

Abstract

The present thesis studies two distinct issues, namely merger waves and optimal contracts for delivery in settings with time to build. The first part of the thesis proposes a theoretical explanation for the occurrence of merger waves. Mergers and acquisitions (M&A) come in waves, a fact that has puzzled economists as far back as the 1950's. Accordingly, there exists a vast empirical literature studying the time-series properties of M&A activity, and numerous studies devoted to identifying correlation between M&A activity and economic and financial variables. A review of merger theory is presented in the first chapter. In the second chapter, a formal model is developed that incorporates both dependenceo f the merger decisiono n macroeconomic variables and strategic interaction between firms. Specifically, a model is set up in which a number of acquiring firms compete over time for a small number of target firms. In each period, an acquirer may either attempt a takeover, or postpone the takeover decision. By delaying a takeover attempt, the acquiring firm may gain from more favourable future market conditions. On the other hand, postponement of the takeover involves the risk of preemption from rivals. This tradeoff leads to equilibria in which all acquirers simultaneously seek to merge. An extension of the model into one of incomplete information (i. e. a setting in which there is strategic uncertainty) allows one to pin down a unique perfect Bayesian equilibrium, and thus the expected timing of the merger wave. The second part of the thesis studies contractual relationships between economic agents in situations where there is time to build. Specifically, it seeks to analyse how delivery time is determined under asymmetric information. In order to do this, two different models are presented, each one focusing on a separate issue. The first is a continuous time adverse selection model in which a principal hires an agent to complete a project, but where the agent's ability is private information and unknown to the principal. Furthermore, the principal is unable to monitor the agent's rate of effort or progress on the project. In this setting the optimal contract is derived and characterised. The main finding is that the principal can use completion time to screen agents of different efficiency. The optimal contract thus specifies wages as a function of completion time in a way that optimally trades off efficiency with informational rents. It turns out that the optimal contract has the most efficient agent deliver at the efficient point in time, paying him large informational rents. For less efficient agents, the optimal contract stipulates inefficient delay in delivery time, with the most inefficient agent receiving no informational rents, The second model is one of dynamic moral hazard, in which the agent's effort is unobservableto the principal. In order to complete the project, the agent must successfully complete a sequence of distinct tasks in a fixed pre-specified order. Whether or not a task is completed depends on the agent's effort. In this setting, different contracts are analysed. Namely, the cases of observable effort and unobservable effort with spot contracting are characterised, The analysis shows that under both scenarios, project delays are most likely to occur in early stages of development, and are related directly to the power of the offered incentive scheme. Last, contracts with commitment on the part of the principal are discussed.