The Informativeness Principle Under Limited Liability

24 Pages Posted: 25 Sep 2014

See all articles by Pierre Chaigneau

Pierre Chaigneau

Queen's University

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Daniel Gottlieb

Paul Baerwald School of Social Work

Multiple version iconThere are 4 versions of this paper

Date Written: September 2014

Abstract

This paper shows that the informativeness principle does not automatically extend to settings with limited liability. Even if a signal is informative about effort, it may have no value for contracting. An agent with limited liability is paid zero for certain output realizations. Thus, even if these output realizations are accompanied by an unfavorable signal, the payment cannot fall further and so the principal cannot make use of the signal. Similarly, a principal with limited liability may be unable to increase payments after a favorable signal. We derive necessary and sufficient conditions for signals to have positive value. Under bilateral limited liability and a monotone likelihood ratio, the value of information is non-monotonic in output, and the principal is willing to pay more for information at intermediate output levels.

Keywords: contract theory, Informativeness principle, limited liability, options, pay-for-luck, principal-agent model, relative performance evaluation

JEL Classification: D86, J33

Suggested Citation

Chaigneau, Pierre and Edmans, Alex and Gottlieb, Daniel, The Informativeness Principle Under Limited Liability (September 2014). CEPR Discussion Paper No. DP10143, Available at SSRN: https://ssrn.com/abstract=2501626

Pierre Chaigneau (Contact Author)

Queen's University ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

Alex Edmans

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Daniel Gottlieb

Paul Baerwald School of Social Work ( email )

Jerusalem
Israel

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