The Value of Informativeness for Contracting

62 Pages Posted: 6 Oct 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 3 versions of this paper

Date Written: October 2014

Abstract

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 precision -- since we typically cannot solve for the optimal contract and analyze how it changes with informativeness. We consider a standard agency model with risk-neutrality and limited liability, where the optimal contract is a call option. The direct effect of reducing signal volatility is a fall in the value of the option, benefiting the principal. The indirect effect is a change in the agent's effort incentives. If the original option is sufficiently 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 reduces effort incentives. As the agency problem weakens, the gains from precision fall towards zero, potentially justifying pay-for-luck.

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 Value of Informativeness for Contracting (October 2014). CEPR Discussion Paper No. DP10180, Available at SSRN: https://ssrn.com/abstract=2506016

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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