Joel S. Demski

Optimal incentive contracts with multiple agents

Abstract A setting in which a single principal contracts with two agents who possess perfect private information about their own productivity is considered. With correlated productivities, each agents private information also provides a signal about the other agents productivity. In contrast to the setting in which there is only one agent, it is shown that such private information may be of no value to the agents. It is only if the agents are risk-averse that their private information may allow them to command rents. Moreover, when the agents are constrained only to reveal their private information truthfully as a Nash equilibrium, the Pareto optimal incentive scheme may induce the agents to adopt strategies other than truth-telling. This leads to the consideration of truth-telling equilibria that are not Pareto dominated in the subgame played by the agents. Among all such equilibria, the one preferred by the principal restricts one agent to tell the truth as a dominant strategy and the other as a Nash response to truth.

Market response to financial reports

Abstract A two-date rational expectations model is analyzed. At the first date, traders can privately acquire a costly signal that provides imperfect information about a public report that will be issued at the second date. Equilibrium characterizations are provided for the fraction of traders that become informed and the informativeness of the first-date price, as well as the price change variance and the expected trading volume at the second date. Comparative statics identify how the above variables are influenced by changes in the information content of the public report, and in particular how market phenomena at the public release date are influenced by endogenous prior information acquisition and trading in response to the forthcoming public release.

Performance Measure Garbling Under Renegotiation in Multi-Period Agencies

We present a two-period model in which the parties cannot commit to not renegotiate their contractual arrangement in mid-game. This is of interest because, institutionally, parties can always agree to renegotiate their arrangement and because this single friction is sufficient to induce endogenous performance measure manipulation. As is well known (e.g., Dye [1988] and Arya, Glover, and Sunder [1998]), accounting manipulation is a type of garbled communication between parties and will be a compelling phenomenon only when a revelation representation is not possible.1 Such a representation requires a rich message space, commitment to the contracted use of the communication, and, of course, an optimal contract. All requirements have been weakened in one form or another. For example, Dye [1988], Evans and

Managing Supplier Switching

To examine the potential gains from a second production source, we examine how source switching is optimally structured. The model focuses on a purchaser who manages the acquisition process, an incumbent supplier, and a potential entrant or second supplier. Because the costs of the incumbent and second source are correlated, the entrants costs provide an informative signal about the incumbents costs. Judicious use of this information allows the purchaser to limit the incumbents rents. Because entry also provides an alternative source of production, however, there are important distinctions between the optimal entry policy and the optimal auditing policy. One of our findings is that it may be optimal to replace the incumbent, even when the entrant is known to have higher production costs.

Corporate Conflicts of Interest

This paper surveys conflicts of interest in the corporate governance arena, with emphasis on auditors, boards of directors, analysts and investment bankers, regulators, management, attorneys and investors. Enron provides a host of examples as well. I stress the multifaceted nature of these conflicts, and the fact most research looks at some conflicts, such as auditor independence, absent the larger setting and potential interactions among various players. I further speculate herding behavior is an important explanatory device in understanding periodic failures.

Hierarchical Regulatory Control

We consider a regulatory problem in which there is a hierarchy of control. Consumers (or Congress) direct the activities of a regulator, who, in turn, oversees the activities of a monopolistic firm. Both the regulator and the firm are self-interested actors. The regulator must be motivated to acquire the expertise that allows him to control the firms activities more effectively. The firm must be motivated to produce at minimal cost to consumers. We characterize the distortions in the firms activities that are optimally induced to control more effectively the activities of the firm and the regulator.

NATURE OF FINANCIAL ACCOUNTING OBJECTIVES - SUMMARY AND SYNTHESIS

The nature and the specification of financial accounting objectives are issues that recently have received considerable attention. Nontrivial resources have been expended by public accounting firms and by the AICPA Objectives Committee, among others, in attempting to specify what these illusive objectives might, or should, be. There seems to be a consensus that the primary purpose of financial reporting is to provide information to financial statement users. Yet, the basic, fundamental role of objectives within this utilitarian, user-primacy framework remains obscure-largely, we speculate, because the problem of heterogeneous users has not been forcefully addressed. That is, explicit recognition of irreconcilable conflicts of interest among user classes (or users) provides the key element in defining the objectives issue. A basic purpose of this summary and synthesis, then, is to offer a view of the nature and role of financial accounting objectives that explicitly rests on heterogeneous users. The argument is presented in six stages. Initially, we provide a summary description of the problem of selecting among competing financial accounting alternatives. In the second section we explicitly formulate the user-primacy or utilitarian notion. Following this is a discussion of the basic nature of objectives. We then discuss the role of accounting research in this scheme, analyze the papers presented at this conference in terms of the framework developed, and finally explore some areas for further research on the objectives issue.

Accounting Policies in Agencies with Moral Hazard and Renegotiation

We emphasize the role of accounting policies, and their audit, in an earnings management setting. We use a two–period agency in which three frictions interact: the agent privately observes action (or effort) supply and output, and the initial contract is subject to renegotiation. This creates a setting in which both players’ behavior is of concern, and, importantly, information rationing is efficient. Moreover, this information rationing is directly interpretable as being produced by an accounting policy whose application is ensured by an auditor.

Incentive schemes with multiple agents and bankruptcy constraints

Abstract We explore the effects of bankruptcy constraints on incentive schemes when two risk-neutral agents operate in correlated environments. Our focus is on the subgame equilibrium in which each agent is induced via a direct mechanism to truthfully reveal his private information as a Nash response to truth-telling by his counterpart. We identify a class of examples in which, in contrast to the case where the agents are risk-averse, the Nash constraints induce a subgame dominant strategy equilibrium. Thus implementation via direct mechanisms is feasible for this class. More generally, however, the truth-telling Nash equilibrium may be subgame dominated, so the question of implementation via direct mechanisms remains a delicate one.

Product Costing in the Presence of Endogenous Subcost Functions

We study a multiproduct setting in which the underlying technology permits identification of economic subcost functions. We then explore the ability of various accounting procedures to produce relatively accurate marginal cost estimates. This ability varies with the underlying technology, as well as among the products. Moreover, a portfolio perspective emerges: with errors varying among the products the issue of where in product space to tolerate relatively large costing errors in order to help ensure relatively small costing errors in other products arises.