Value of information for contracting

Finance

European Corporate Governance Institute - Finance Working Paper

Chaigneau P;Edmans A;Gottlieb D

Alex Edmans

2017

The informativeness principle demonstrates qualitative benefits to increasing signal precision. However, it is difficult to quantify these benefits -- and compare them against the costs of monitoring -- since we typically cannot solve for the optimal contract and analyze how it changes with precision. We consider a standard agency model with risk-neutrality and limited liability (as in Innes (1990)), where the optimal contract is a call option. The direct effect of reducing signal volatility is a fall in the value of the option and thus the agent's expected wage, benefiting the principal. The indirect effect is a change in the agent's effort incentives. If the original option is deeply out-of-the-money, the agent can only beat the strike price if he exerts effort and there is a high noise realization. Thus, a fall in volatility weakens effort incentives. As the agency problem becomes weaker, the gains from increased precision fall towards zero. These results potentially justify pay-for-luck and the absence of relative performance evaluation. Separately, increases in informativeness lead to at-the-money options being optimal.

Executive compensation; Pay-for-luck; Principal-agent model; Relative performance evaluation; Options; Contract theory; Agency theory

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European Corporate Governance Institute - Finance Working Paper

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