Harvard University

Economics 2060 Contract Theory

Problem Set 3
This problem set is due by the end of the lecture on Monday, December 8, 2008. Please
place problem sets in Georgy Egorovs mailbox on the second oor of the Littauer Center or
hand in in person. Please email gegorov@fas.harvard.edu with any questions.
1. Multi-Task and Incomplete Contracts
Consider the relationship between a shipper o and a trucker 1. o hires 1 to carry a load from
Boston to Chicago. When 1 arrives in Chicago, o will have another load (the back-haul)
whose characteristics cannot be specied in a contract in advance. The value of this load
is . While driving from Boston to Chicago, 1 can engage in two activities: she can search
for an alternative back-haul, and she can look after the truck. Alternative back-hauls have
value
2
with probability j and
1
with probability 1j, where
2

1
, and
2

1
< 1.
The probability j is a choice variable for the trucker and the eort cost of j is j
2
2. The
value of the truck, , is also a choice variable for the trucker and the eort cost of is
\
2
2. There is symmetric information throughout, but is not veriable and contracts
on the back-haul cannot be written until the trucker reaches Chicago. Both parties are risk
neutral and there is no discounting.
1. Solve for the rst-best levels of j and .
2. Assume that the trucker owns the truck. Take this to mean that (i) in the absence
of renegotiation, the trucker has the right to take the alternative back-haul, and the
shippers payo is zero (since there are no other truckers to carry her load); (ii) the
trucker receives the full value of the truck, (she is the residual claimant). Suppose,
however, that renegotiation takes place if the alternative back-haul is inecient, and
that this proceeds according to Nash bargaining with a 50 : 50 split. Solve for the
second-best values of j and .
3. Assume now that the shipper owns the truck. Take this to mean that: (i) in the absence
of renegotiation, the trucker does not have the right to take the alternative back-haul,
and so receives zero, and the shipper also receives zero (since she needs the trucker to
carry his load); (ii) the shipper receives the full value (she is the residual claimant).
Suppose again that renegotiation takes place as above. Solve for the second-best values
of j and .
4. Provide conditions under which trucker ownership is optimal, and conditions under
which that shipper ownership is optimal. Discuss the trade-o between shipper and
trucker ownership.
2. Holdup Problem
There are two contracting parties, a prospective buyer (1) and prospective seller (o). The
sellers cost of production of the good is c 2 fc
L
. c
H
g, P(c = c
L
) = i, and the buyers
1
valuation of the good is 2 f
L
.
H
g, P( =
H
) = ,, where i and , are sellers and
buyers investments; their costs are c(i) and (,), respectively (convex, satisfying c(0) = 0.
c
0
(0) = 0, c(1) = 1, same for ). Assume
H
c
H

L
c
L
.
The timing is as follows: rst, the parties sign a contract, then they undertake investments
i and ,, then c and are realized, and then the contract is fullled.
1. Characterize the rst best. What are the investments? What is the probability of
trade?
2. Assume that only spot contracting (after investments are made and c and are realized)
is possible. Moreover, the surplus from contracting is split 50 : 50. Will the investments
be higher than, equal to, or less than rst-best ones, and why?
3. Now assume that the 1 makes a take-it-or-leave-it oer (. j) to o at the time of
spot contracting (and thus takes all surplus from the trade, if any). Will 1 make the
ecient investment? What about o? (Here, is the probability that trade occurs, so
= 1 if there is trade and = 0 otherwise.)
4. Suppose that prior to investing, the parties may sign a default specic performance
contract (~ . ~ j), which is fullled if o rejects the 1s take-it-or-leave-it oer (. j) which
1 makes after c and are realized. Does this contract achieve ex-post eciency? Is it
possible to achieve ex-ante eciency? (The probability of trade ~ may take any value
in [0. 1].)
5. Suppose that the parties cannot write a contract on probabilities (the court cannot
verify whether a fair coin was thrown). So, ~ must be 0 or 1, which makes the specic
performance contract infeasible. Can an option contract help achieve the rst-best
level of investment? (In the option contract, j
0
and j
1
, i.e. prices if there is no trade and
if there is trade, are specied, and whether to supply good or not is sellers discretion,
unless the parties renegotiate.)
3. Public vs. Private Ownership
This is based on Hart-Shleifer-Vishny article The proper scope of government: theory and
application to prisons.
The government (G), wants a certain good to be provided to consumers (the good is prison).
The good is produced by a manager ` using asset . ` is a bureaucrat if the government
owns , and entrepreneur if she owns . Independently of the ownership structure, the
government can sign a long term contract with ` that species some aspects of the good
to be provided. Those aspects and contingencies contemplated in the contract dene the
so-called basic good which costs (
0
to the manager to produce, yields surplus 1
0
to society
and it is payed 1
0
by G.
Some other aspects of the good are noncontractible and ` can modify those nonveriable
characteristics by choosing the two eort levels, c and i. The rst is aimed at cost reduction
but it also gives rise to quality deterioration; namely, an efort level c causes cost and benet
variations of ( = 2:
p
cc and 1 = c respectively where : 0 and 2 (0. 1). The
second is instead a direct investment in quality improvement: an eort level of i generates
2
a benet variation 1 = 2
p
i where 0. Actions c and i cost to `, respectively, c and
i. Assume that any cost or quality change can only be implemented with the agreement of
the owner of . The timing of the relationship is the following:
t = 0 : ` and G write contract and choose ownership structure.
t = 12 : ` chooses i and c.
t = 1 : The parties renegotiate and split the surplus as dened below. (If they do not
renegotiate, the basic good is provided.)
Assume that a fraction \ 0 of the returns to innovations is embodied in `s human capital,
that is, G can only enjoy a fraction (1 \) of those returns if renegotiation fails (i.e. if G
walks away with the asset). Suppose also that parties split the surplus from renegotiation
50 : 50.
1. Find the rst best solution.
2. What are the payos to the parties under ` and G ownership, respectively? Comment.
3. Compare second best eort levels under the two arrangements and discuss their relation
with rst best eorts.
4. How is the optimal ownership structure determined? What is the trade-o involved in
the choice?
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