Edward Simpson Prescott

Firms as Clubs in Walrasian Markets with Private Information

We incorporate multiagent, principal-agent theory into general equilibrium analysis. The traded commodities are multiagent contracts that include a description of the individuals job, effort level, and state-contingent consumption. These contracts are club goods. The competitive equilibrium and the Pareto program are formulated. The contracts are identified with firms, so the market determines which firms exist and who is assigned to which firm in what capacity. An example is provided in which the internal organization of firms and the distribution of firm classes vary with the aggregate capital endowment and its distribution across agents. A simplex-based algorithm for solving the Pareto program is developed.

Collective Organizations versus Relative Performance Contracts: Inequality, Risk Sharing, and Moral Hazard☆

Abstract This paper studies collective economic organizations that share risk and mitigate moral hazard and compares them with relative performance contracts. Information-constrained optimal distributions of organizations and contracts are shown to be functions of the underlying primitives, in particular, the distribution of Pareto weights, and hence degree of inequality. Internal inequality of a potential, local group is a force for collective organization. That is, multi-agent organizations exist in order to extract wealth from some but not necessarily all members. The group organization is also shown to be information-constrained Pareto optimal at extremes of local wealth relative to an outsider. But the group organization is susceptible to both agents simultaneously deviating, colluding against the outsider, and this distortion makes an individualistic, relative performance contract an attractive alternative. More generally, organizations, contracts, and allocations are jointly determined. These implications could be distinguished in cross-sectional, time series data. Journal of Economic Literature Classification Numbers: D70, D82.

Contingent Capital: The Trigger Problem

In this article, we analyze price triggers in contingent capital bonds. We illustrate the pervasiveness of multiple equilibria and the nonexistence of equilibrium in theoretical models. We summarize evidence of these problems from market experiments and we evaluate possible solutions.

Computing solutions to moral-hazard programs using the Dantzig–Wolfe decomposition algorithm

Abstract Linear programming is an important method for computing solutions to private-information programs. The method is applicable for arbitrary specifications of preferences and technology. Unfortunately, as the cardinality of underlying sets increases, the programs quickly become too large to compute. This paper demonstrates that moral-hazard programs have a structure that allows them to be computed using the Dantzig–Wolfe decomposition algorithm. This algorithm breaks the linear program into subprograms, greatly increasing the size of programs that may be practically computed. Two examples are computed. The role of action lotteries is discussed.

Theory of the firm: applied mechanism design

This paper studies the question: Why are there Firms? Motivated by observations of a variety of economies, several distinct concepts of what it means to be a firm are identified and then analyzed with mechanism design models. In the first class of models, a group of individuals is a firm if they collude and share information. This model is analyzed and compared with the non-firm alternative. Conditions are provided in which firms are preferred to no firms and vice versa. Next, we show how an economy with multiple distinct groups of colluding individuals can be decentralized. ; In the next class of models, collusion is prohibited, but the information structure of the economy depends on whether individuals work together. Activities performed jointly by the individuals are considered to be done with a firm. In the model the degree of economic activity organized by firms is endogenous. Numerical examples are provided in which none, some, and all work is done within a firm. The last class of models studies the long-term nature of firms versus the short-term nature of non- firm arrangements, like spot markets. Multi-stage models are developed in which individuals may be switched between projects. People who work the same project over time are considered to work for a firm. Conditions for the optimality of long-term and short-term arrangements are provided.

An Experimental Analysis of Contingent Capital Triggering Mechanisms

This paper reports an experiment that evaluates three regimes for triggering the conversion of contingent capital bonds into equity: (a) a ?regulator? regime, where socially motivated regulators make conversion decisions based on observed prices, (b) a ?fixed trigger? regime where a price threshold triggers a mandatory conversion, and (c) a ?prediction market? regime where we supplement the regulator?s information set with the results of a prediction market that elicits traders? perceived likelihood of a conversion. Consistent with theory, we observe informational and allocative inefficiencies as well as numerous errors in conversion decisions in both the regulator and fixed trigger regimes. Contrary to theory, however, we also observe inefficiencies and frequent conversion errors in the prediction market regime. Although the fixed trigger and prediction market regimes are more informationally efficient than the regulator regime, allocative efficiencies remain low and conversion error rates high in all three regimes. ; Earlier title: Market-based corrective actions - an experimental investigation

Incentives, Communication, and Payment Instruments

Alternative payment instruments are studied in an economy with private information, delayed communication, and limited commitment. Attention is restricted to checks and bank drafts, which differ in resource cost and communication characteristics. Checks are less costly but settlement delays create a limited commitment constraint. We find that drafts dominate at low wealths and checks at higher wealths. Applications to 19th century and modern payment systems are discussed.

Communication in Private-Information Models: Theory and Computation

Communication and no-communication versions of a two-stage principal-agent model are compared. The models contain a risk-averse agent and two sources of private information, a shock to preferences followed by a productive action. Both models are formulated as linear programs, which are then used to compute solutions to examples. For the communication model, an alternative method of accounting for the utility from off-equilibrium strategies is derived. This method greatly reduces the size of the linear program. For the no-communication model a Revelation-Principle like proof is provided. In simple cases, a sufficient condition for communication to be valuable is derived. In these cases, communication improves risk-sharing in bad states of the world. In more complicated cases, computed examples demonstrate how communication may also alter labor supply. Further examples demonstrate how action and consumption lotteries may separate agents by their shock.

Optimal Bonuses and Deferred Pay for Bank Employees: Implications of Hidden Actions with Persistent Effects in Time

We present a sequence of two-period models of incentive-based compensation in order to understand how the properties of optimal compensation structures vary with changes in the model environment. Each model corresponds to a different occupation within a bank, such as credit line managers, loan originators, or traders. All models share a common trait: the effects of hidden actions are persistent, and hence are revealed over time. We characterize the corresponding optimal contracts that are consistent with prudent risk taking. We compare the contracts by ranking them according to the average wage, the proportion of deferred compensation, and the structure and importance of variable pay (bonuses). We also compare these characteristics of the models with persistence with those of a standard repeated moral hazard. We find that small changes in the structure of asymmetric information have important implications for the characteristics of optimal pay, and that persistence does not necessarily imply a higher proportion of deferred pay.

Market-Based Regulation and the Informational Content of Prices

Various laws and policy proposals call for regulators to make use of the information reflected in market prices. We focus on a leading example of such a proposal, namely that bank supervision should make use of the market prices of traded bank securities. We study the theoretical underpinnings of this proposal in light of a key problem: if the regulator uses market prices, prices adjust to reflect this use and potentially become less revealing. We show that the feasibility of this proposal depends critically on the information gap between the market and the regulator. Thus, there is a strong complementarity between market information and the regulators information, which suggests that regulators should not abandon other sources of information when learning from market prices. We demonstrate that the type of security being traded matters for the observed equilibrium outcome and discuss other policy measures that can increase the ability of regulators to make use of market information.