Asymmetric Information Model Research Articles

Principal-agent contracts in continuous time asymmetric information models the importance of large continuing information flows

There are large information flows between principals and agents in certain settings. They may be captured by continuous time models which are typically modelled as Brownian motion. This paper points out that principal-agent contracts in these models should recognise that, such is the amount of information in the flow of output of these models, the variance of a Brownian motion process can be calculated by the principal from any time span of data no matter how short, and thus the variance is public information. If the variance is open to choice, the principal has much more control over the agent than has hitherto been appreciated. This argument is preserved even if the agent mis-reports data in certain ways. The approach is applied to principal-agent examples which have received attention in the literature.

Bargaining and Waiting

Until recently the final word on bargaining with full information had been Rubinstein's (1982) seminal work which concluded that an agreement will be reached immediately, and the first mover will have the advantageous share. Rubinstein's model was one of alternating offers made at fixed time intervals. Many variations of the model have emerged, and until recently, they mainly focus on asymmetric information' with some having the uninformed agent making all the offers. The conclusion from examining these variations is that the equilibrium is highly sensitive to the exact specification of the institutional structure. In more recent work, Perry and Reny (1990), Perry and Reny (1993), Sakavics (1993), and Nickerson, Sadanand and Sadanand (1994) endogenize the structure of the bargaining by allowing the order and timing of play to be determined endogenously. The first three papers (endogenous structure models) deal with the full information setting and the last is an asymmetric information model.2 In addition to the exogenously given minimum reaction time (for responding to offers made by the other player), the endogenous structure models introduce the important innovation of an exogenous waiting time, a time between a player's offer and his next offer. They also allow players to make simultaneous offers which Sakovics later disallows. The findings in this recent literature are rather startling: (i) The waiting time has a profound impact; the longer the time, the greater the share the player can command.3 (ii) The consequence of simultaneous offers is multiple equilibria: when the reaction time is zero, a continuum of shares lying between the two unique Rubinstein shares can result, and additional continua of shares arise with delayed agreement when the reaction times are positive. (iii) Equilibrium paths are almost exclusively characterized by simultaneous offers. In this paper we examine the question of simultaneous offers and reconcile the conflict between the infrequency of simultaneous offers in real life bargaining and their prevalence in the endogenous structure models. We

BID‐ASK SPREAD AND OWNERSHIP STRUCTURE

AbstractIn this paper we examine the relation between bid‐ask spread and ownership structure variables based on 1985 data for 1,063 NYSE firms. We document a nonpositive relation between bid‐ask spread and insider ownership and conclude that spread is unrelated to insider trading. We also find a robust significantly negative relation between spread and institutional ownership. Finally, we find a positive but generally insignificant relation between spread and blockholdings. Overall, our evidence does not support the predictions of asymmetric information models in markets with anonymous trading.

Depth of knowledge and the effect of higher order uncertainty

A number of recent papers have highlighted the importance of uncertainty about others' information in models of asymmetric information. We introduce a notion that reflects the depth of knowledge in an information system. We show how the depth of knowledge can be used to bound the effect of higher order uncertainty in certain problems. We further provide bounds on the size of bubbles in finite horizon rational expectations models where the bounds depend on the depth of knowledge.

Aid Conditionality and Military Expenditure Reduction in Developing Countries: Models of Asymmetric Information

This paper analyzes problems of implementing noneconomic conditionality, such as military expenditure reduction, in the granting of foreign aid given the presence of asymmetric information. The authors present two conceptually separate principal-agent models to capture the stylized facts of multilateral and bilateral aid negotiations respectively. The first model is an application of the problem of adverse selection when there is more than one type of principal (donor) with varying objectives. The second model extends moral hazard to double moral hazard, where neither principal nor agent (recipient) can fully observe or verify each other's strategies. Copyright 1995 by Royal Economic Society.

Contractual Contingencies and Renegotiation

In a dynamic model of asymmetric information between the owner of a firm and a manager, we investigate the optimal set of contingencies on which an incentive contract should depend when renegotiation is possible. In particular, we characterize the circumstances in which the contracting parties find it desirable to deliberately restrict what the owner can monitor, thereby limiting the contractible contingencies. Our findings thus provide an endogenous explanation for contract simplicity, in contrast to those based on transactions costs or bounded rationality.

What do firms do with cash windfalls?

Suppose that a firm receives a cash windfall which does not change its investment opportunity set or, equivalently, its marginal Tobin's Q. What will this firm do with the money? We provide empirical answers to this question using a sample of eleven firms with such windfalls in the form of a won or settled lawsuit. We examine a variety of decisions of the firm to shed light on alternative theories of corporate financing and investment. Our evidence is broadly inconsistent with the perfect capital markets model. The results need to be stretched considerably to fit the asymmetric information model in which managers act in the interest of shareholders. The evidence supports the agency model of managerial behavior, in which managers try to ensure the long-run survival and independence of the firms with themselves at the helm.

Bid—ask spreads and volatility in the foreign exchange market: An empirical analysis

Consistent with the implications from a simple asymmetric information model for the bid-ask spread, we present empirical evidence that the size of the bid-ask spread in the foreign exchange market is positively related to the underlying exchange rate uncertainty. The estimation results are based on an ordered probit analysis that captures the discreteness in the spread distribution, with the uncertainty of the spot exchange rate being quantified through a GARCH type model. The data sets consists of more than 300,000 continuously recorded Deutschemark/dollar quotes over the period from April 1989 to June 1989.

Asymmetric Information and the Selection of Disputes for Litigation

WHAT explains the decision to litigate rather than settle a dispute? The standard theoretical approach to this question is a contract model that suggests that parties will litigate when the set of mutually beneficial settlement agreements-that is, the contract zone-is empty.' The contract zone may be empty because the parties have divergent expectations of the trial outcome or because one party has more at stake than the other.2 The divergent-expectations explanation suggests that there are general respects in which litigated disputes differ from settled disputes and that one need not know the identities of litigants or the specific area of litigation in order to understand the differences between litigated and settled disputes. The differential-stakes explanation implies that such information is necessary.3 The divergent-expectations theory of selection was developed in large

The Role of Fiscal Policy in an Incomplete Markets Framework

A general-equilibrium model is developed to highlight the link between neo-Keynesian models of unemployment and recent results on the constrained sub-optimality of competitive economies with incomplete asset markets. Although the model deviates from the Arrow-Debreu paradigm only by the absence of some contingent claims, the competitive equilibrium exhibits under-employment and balanced-budget fiscal policies have Keynesian effects which are Pareto improving. Will a market economy, left to itself, fully employ its resources? In The General Theory, Keynes exploited several mechanisms through which real economies differ from the classical paradigm where unemployment is either voluntary or non-existent. A common characteristic of these mechanisms is the difficulty of coordinating production and consumption plans in a decentralized economy. In recent years neo-Keynesians have sought to develop general-equilibrium models from micro foundations where this coordination problem can be analyzed. These efforts are of interest for two reasons. First, as an intellectual exercise it is of interest to explore which deviations from the classical paradigm are necessary and/ or sufficient to generate Keynesian effects. Second, from a policy perspective, it is important to start from micro-foundations to verify the welfare implications of policy. The neo-Keynesian literature has gone in several directions. We will not review them here.' At this point it is sufficient to note that the argument developed below is based on incomplete financial markets and thus is related to the asymmetric information models of Greenwald and Stiglitz.2 The main contribution of this paper is the development of a model where we can make the following three points: 1) The Keynesian coordination problem can arise naturally in a competitive system with perfectly flexible prices and rational expectations. 2) The mechanism underlying the coordination problem is related to recent work on the constrained sub-optimality of competitive equilibria with incomplete markets. As such, the coordination problem is generic to this and other models with incomplete financial markets. 3) Familiar, and feasible, policies can be welfare improving even though they do not directly address the fundamental microeconomic causes of the coordination failure. We study in detail the welfare effects of two fiscal policies and discuss briefly how other policies can be studied within this model.

The Role of Household Production in Models of Involuntary Unemployment and Underemployment

A classic result in the theory of labor contracts with asymmetric information is that underemployment results if and only if leisure is an inferior good. A classic result in models where unemployment occurs because of indivisibilities, including implicit contract models and some equilibrium macroeconomic models, is that unemployment is involuntary if and only if leisure is an inferior good. The authors introduce household production into otherwise standard versions of these models and show that this implies they can have underemployment in asymmetric-information models or involuntary unemployment in indivisible-labor models without assuming that leisure is inferior.

Adverse selection and equilibrium in liability insurance markets

Models of asymmetric information in insurance markets typically consider insurance buyers with Bernoulli loss distributions differing in expected loss. This article analyzes markets where buyer loss distributions are characterized by mean-preserving spreads and insurers can classify applicants in terms of expected values but not by risk. Because liability losses are characterized by skewed continuous probability distributions, both discrete and continuous loss distributions are considered. In contrast to the single separating equilibrium in the classic Rothschild-Stiglitz insurance market, multiple separating equilibria are identified in this article: three in the discrete case and four in the continuous case. The possibility of extreme discontinuities in insurer policy offers provides a new explanation for crises in liability insurance markets.

Correlated Information and Mecanism Design

In models of asymmetric information, possession of private information leads to rents for the possessors. This induces mechanism designers to distort away from efficiency. The authors show that this is an artifact of the presumption that information is independently distributed. Rent extraction in a large class of mechanism design games is analyzed, and a necessary and sufficient condition for arbitrarily small rents to private information is provided. Additionally, the two-person bargaining game is shown to have an efficient solution under first-order stochastic dominance and a hazard rate condition. Similar conditions allow full rent extraction in Milgrom-Weber auctions.

Layoffs and Lemons

We provide theoretical and empirical analyses of an asymmetric-information model of layoffs. When firms have discretion with respect to whom to lay off, the market infers that laid-off workers are of low ability. Assuming that no such negative inference is warranted if workers are displaced in a plant closing, postdisplacement wages should be lower and postdisplacement unemployment spells should be longer for those displaced by layoffs than for those displaced by plant closings, but predisplacement wages should not differ by cause of displacement. Evidence on displaced workers from Current Population Surveys supports all three of our model's predictions.

Market Microstructure Effects of Government Intervention in the Foreign Exchange Market

An asymmetric information model of the bid–ask spread is developed for a foreign exchange market subject to occasional government interventions. Traditional tests of the unbiasedness of the forward rate as a predictor of the future spot rate are shown to be inconsistent when the rates are measured as the average of their respective bid and ask quotes. Larger bid–ask spreads on Fridays are documented. Reliable evidence of asymmetric bid–ask spreads for all days of the week, albeit more pronounced on Fridays, are presented. The null hypothesis that the forward rate is an unbiased predictor of the future spot rate continues to be rejected. The regression slope coefficients increase toward unity, however, indicating a less variable risk premium.

Strikes and Wages: A Test of an Asymmetric Information Model

This paper describes a simple model of labor disputes based on the hypothesis that unions use strikes to infer the profitability of the firm. The model posits the existence of a negatively sloped resistance curve between wages and strike duration. In addition, it offer a series of predictions relating wage and strike outcomes to changes in the expected profitability of the firm and changes in the alternative opportunities of striking workers. These implications are tested using data on wage outcomes, strike probabilities, and strike durations for a large sample of collective bargaining agreements.

Contract renegotiation in models of asymmetric information∗

Contract renegotiation in models of asymmetric information∗

Interest Arbitration and the Incentive to Bargain

This article develops an asymmetric information model of final-offer arbitration. If the union negotiator has superior information about the bargaining environment, then the union rank and file may find it in their best interest to require their negotiator to go to arbitration some of the time. In a simple two-state model, it is shown that if arbitration is rational for the union rank and file, it will occur only in the state where the bargaining environment is unfavorable to the union.

DETERMINANTS OF VALUATION EFFECTS FOR SECURITY OFFERINGS OF COMMERCIAL BANK HOLDING COMPANIES

AbstractIn this study, the impact of security issuance by bank holding companies is examined in light of two hypotheses: the regulation or asymmetry reduction hypothesis and the bank capital hypothesis. Announcements of the issuance of common stock are associated with a significant negative effect, and the magnitude of this effect is similar to that found previously for utilities and smaller than that found for industrial firms. The market does not appear to treat subordinated debt announcements as similar to equity, although the debt qualifies as “capital” for regulatory purposes. Cross‐sectional regressions do not support asymmetric information models where all unexpected external announcements are viewed negatively. Rather, the type of security being issued is an important determinant of the announcement effect.

Testing in Models of Asymmetric Information

This paper explores the role of testing in models of asymmetric information. We demonstrate conditions under which testing for underlying characteristics can overcome adverse selection problems and lead to a full-information competitive equilibrium. This paper provides a more general statement of Mirrlees result on the optimal use of infinite fines. Where testing cannot fully resolve the problems associated with asymmetric information, we outline the source of the difficulties. Our results, developed in the context of a labour market, can be directly extended to other environments. In problems with asymmetric information, testing to discover an agent's chosen action or underlying characteristics may significantly reduce the cost of moral hazard and adverse selection.