Abstract
The central purpose of this paper is to examine the incentive contract as an equilibrium phenomenon. We analyse a model of vertical differentiation in which we deal with the strategic role of the competitor’s decisions in a successive duopoly. Is it better for a processor to offer an incentive contract to an upstream producer or the spot market? We determine the equilibrium of a game in which the processors simultaneously decide whether to offer an incentive contract or to continue at the spot market to acquire their input. Our results show that under successive duopoly, offering an incentive contract constitutes the unique equilibrium solution, which highlights the incentive contract persistence.
Highlights
According to principal-agent theory, incentive contracts are needed to elicit “effort” from agents to perform tasks that are valuable to the principal, but onerous to the agent (Milgrom & Roberts, 1992)
The purpose of this paper is to theoretically examine whether the incentive contract can emerge as an equilibrium outcome in vertical relationship with upstream and downstream competition under moral hazard
We find that when the processor chooses the incentive contract, his level of output is larger than the level he could produce when he buys the input at the spot market, no matter what the other processor chooses
Summary
According to principal-agent theory, incentive contracts (i.e., contracts that tie compensation to performance) are needed to elicit “effort” from agents to perform tasks that are valuable to the principal, but onerous to the agent (Milgrom & Roberts, 1992). Many analysis have modelled the incentive contract in different contexts, such as monitoring (Baiman & Demski, 1980; Agrawal, 2002), tournaments (Lazear & Rosen, 1981; Holmstrom, 1982; Green & Stokey, 1983; Mookerjee 1984; Knoeber & Thurman, 1995; Rankin & Sayre, 2000, Hueth & Ligon, 2001), repeated agency contexts (Lambert, 1983; Rubinstein & Yaari, 1983; Radner, 1985; Rogerson, 1985; Spear & Srivastava, 1987; Fudenberg & Tirole, 1990; Ma, 1994; Matthews, 1995; Wickelgren, 2003), and agency models with several principal and agents (Barros & Macho-Stadler, 1998; Ray & Singh, 2001; Serfes, 2005; Dam & Pérez-Castrillo, 2006) All these models have provided a better understanding of the incentive contract under different settings, to the best of our knowledge there are no studies that have paid attention to the strategic implications of the principalschoices.
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