Xiaojian Zhao

Incentives for Unaware Agents

The paper introduces the problem of unawareness into Principal-Agent theory and discusses optimal incentive contracts when the agent may be unaware of her action space. Depending on the agents default behavior, it can be optimal for the principal to propose an incomplete contract (that keeps the agent unaware) or a complete contract. The key tradeoff is that of enlarging the agents choice set versus adding costly incentive constraints. If agents differ in their unawareness, optimal contracts show a self-reinforcing pattern: if there are few unaware agents in the economy optimal contracts promote awareness, if unawareness is wide-spread optimal contracts shroud the contracting environment, thus keeping the agent unaware.

Moral Hazard With Unawareness

The article introduces unawareness of actions into the standard moral hazard model in contract theory. We allow the contracting party (the principal or the agent) to be unaware of his or the other partys actions. The principal may also have an incorrect belief about the awareness of the agent. We provide a solution concept where the principal contemplates the incentive scheme according to his conjecture of the agents mind and also contemplates informing the agent through the contract. In the post-contractual stage, either party may be surprised by the other partys action. Finally, we analyze the value of awareness for each party, and present the negative result that awareness is not always valuable.The article introduces unawareness of actions into the standard moral hazard model in contract theory. We allow the contracting party (the principal or the agent) to be unaware of his or the other partys actions. The principal may also have an incorrect belief about the awareness of the agent. We provide a solution concept where the principal contemplates the incentive scheme according to his conjecture of the agents mind and also contemplates informing the agent through the contract. In the post-contractual stage, either party may be surprised by the other partys action. Finally, we analyze the value of awareness for each party, and present the negative result that awareness is not always valuable.

Multi-Task Agency with Unawareness

The paper introduces the problem of unawareness into multi-dimensional Principal-Agent theory. We introduce two key parameters to describe the problem, the extent and the e ffect of unawareness, show under what conditions it is optimal for the Principal to propose an incomplete or a complete contract, and characterize the incentive power of optimal linear contracts. If Agents differ in their unawareness, optimal incentive schemes can be distorted for both aware and unaware Agents, because, di fferent from standard contract theory, the Single-Crossing Property fails to hold. In this case, even aware Agents can be subject to ine ciently high or low incentives.

Framing Contingencies in Contracts

This paper develops a contracting model in which the principal frames the contract when the agent is unaware of some contingencies, yet is aware that she may be unaware. We call the contract vague if the agent is still unaware of some contingencies after understanding the contract. We show that the optimal contract is vague if and only if the principal exploits the agent. Applying the model to an insurance problem, we show the insuree is free from exploitation if she slightly underestimates the unforeseen calamities. In a contracting problem, whenever the contractor is unaware of the force majeure event, she is exploited by the employer.

Information Manipulation and Climate Agreements

It appears that news media and some pro-environmental organizations have the tendency to accentuate or even exaggerate the damage caused by climate change. This article provides a rationale for this tendency by using a modified International Environmental Agreement (IEA) model with asymmetric information. We find that the information manipulation has an instrumental value, as it ex post induces more countries to participate in an IEA, which will eventually enhance global welfare. From the ex ante perspective, however, the impact that manipulating information has on the level of participation in an IEA and on welfare is ambiguous.

Solution Concepts of Principal-Agent Models with Unawareness of Actions

In numerous economic scenarios, contracting parties may not have a clear picture of all the relevant aspects. A contracting party may be unaware of what she and/or others are entitled to determine. Therefore, she may reject a contract that is too good to be true. Further, a contracting party may actively exert cognitive effort before signing a contract, so as to avoid being trapped into the contractual agreement ex post. In this paper, we propose a general framework to investigate these strategic interactions with unawareness, reasoning and cognition and intend to unify the solution concepts in the contracting context with unawareness. We build our conceptual framework upon the classical principal-agent relationship and compare the behaviors under various degrees of the unaware agent’s sophistication.

Motivated False Memory

Building on the works of Carrillo and Mariotti (2000) and Benabou and Tirole (2002), we formulate an intra-person, multiple-self model of how motivated memory including amnesia and delusion may relate to the individual’s degree of present bias. We posit the notion of (non-)conscious choice in which the individual habituates into being forgetful or delusional to enhance the motivation for one’s future selves. In equilibrium, the model endogenizes the individual’s state of motivated memory and particularly delusion resulting from a high level of present bias. We test our model in a controlled incentivized experiment using the Ravens IQ test and find overall support for its implications except for the significant incidence of positive confabulation. This leads us to extend our basic model to capture this possibility as an equilibrium outcome.People often forget and sometimes fantasize. This paper reports a large-scale experiment on memory errors and their relation to preferential traits including time preference and attitudes toward risk and ambiguity. We observe systematic incidences of false memory in favor of positive events and selective amnesia in forgetting negative events. Intriguingly, both positive delusion and positive confabulation significantly relate to present bias, but this is not the case for positive amnesia. In an intra-person, multiple-self model, we demonstrate that positive false memory, rather than selective amnesia, serves to enhance confidence in ones future self in equilibrium, thereby accounting for our experimental finding.

Economics of Contract Interpretation

The chapter surveys recent developments in economics of contract interpretation. First, we point out the relevance of issue of contract interpretation to contracting problems. We then introduce a general economic model of contract interpretation. It explains why parties write gaps and fairly general terms in contracts, how the court should interpret them, and whether courts should always enforce what contracting parties write. Moreover, we explain why there are contradictions in contracts.

Sunk Cost As a Self-Management Device

The sunk cost effect has been widely observed in individual decisions. Building on an intra-personal self-management game, the paper theoretically shows that the sunk cost effect may stem from an attempt to overcome the under-investment problem associated with a high degree of present bias or to resolve the multi-selves coordination problem when the degree of present bias is low. Especially for individuals with severe present bias, the current self may take a costly action (which is a sunk cost for the future self) to signal the individuals high ability that motivates his future self-disciplining behaviors. In equilibrium, a higher level of sunk cost is more likely to give rise to a higher probability for the individual to continue the project. We then conduct a laboratory experiment. The empirical findings are consistent with our theoretical implications.

Incentive-Compatibility in Financial Contracting with Limited Liability

This paper studies a financial contracting problem where a firm privately observes its cash flow and faces a limited liability constraint. The firms collateral is piecemeal divisible and can only be liquidated continuously by resorting to the service of a costly third party, typically associated with bankruptcy. In this situation, multi-class collateralized debt is optimal, in which the firm makes several debt-like promises with a seniority structure. The decision over continuous and piecemeal liquidation depends on both the cost of introducing the third party and the firms funding need. Allowing the firm to refinance ex-post through surreptitious liquidation may reduce the firms ex-ante payoff, consistent with covenants in debt contracts prohibiting the sale of assets.