Dynamic Agency Research Articles

Optimal regulation of energy network expansion when costs are stochastic

We analyze optimal regulation of the gradual investments in energy networks necessary to accommodate the energy transition. We focus on a real option problem where costs of new network technology are stochastic and not observable to the regulator. We solve for the regulatory scheme that optimally balances timely investments with rent extraction in this dynamic agency context. We then apply this methodology to a situation in which investment can be either in traditional network technology, with observable costs, or using an innovative network technology for which there is asymmetric information on costs. The optimal choice trades off the potential benefits of cheaper expansion with the costs of overcoming information frictions.

Freiheit unter Bedingungen der Zeit? Schellings neuer Zeitbegriff im Nachgang zurFreiheitsschrift

AbstractThe concept of human freedom developed by Schelling in the Freiheitsschrift (1809) prompted him to explore a new concept of time in his Weltalter project. Schelling proposes the ‘generic subjectivity of time’: Time must be understood not as a precondition of dynamism, but rather as an effect of dynamic agency. The articulation of time into its moments, ‘presence’, ‘past’, and ‘future’, is realized through the dynamic contributions (motion, causality, and action) of every single causally involved being. Schelling’s concept thus fundamentally differs from Kant’s concept of time. For Kant, change and dynamism are located in the sensible world, whereas time (as well as space) is the subjective form of our sensible intuition. As such, time must be seen as a precondition of change and dynamism for Kant.

Universal health care - A matter of design and agency?

Universal health care (UHC) is primarily a financing concern, whereas primary health care (PHC) is primarily concerned with providing the right care at the right time to achieve the best possible health outcomes for individuals and communities. A recent call for contributions by the WHO emphasized that UHC can only be achieved through PHC, and that to achieve this goal will require the strengthening of the three pillars of PHC - (a) enabling primary care and public health to integrate health services, (b) empowering people and communities to create healthy living conditions, and (c) integrating multisectoral policy decisions to ensure UHC that achieves the goal of "health for all." "Pillars" - as a static metaphor - sends the wrong signal to the research and policy-making community. It, in fact, contradicts the WHO's own view, namely that there is "the need to strengthen comprehensive primary health care systems based on local priorities, needs and contexts … [that are] co-developed by people who are engaged in their own health." What we really need to develop PHC as the basis to achieve the goal of UHC is a dynamic agency to drive a "system-as-a-whole framework" that simultaneously takes into account finance, individual, and local needs. Health systems are socially constructed organizational systems that are "functionally layered" in a hierarchical fashion - governments and/or funders at the top-level not only promote the goals of the system (policies) but also constrain the system (rules, regulations, resources) in its ability to deliver. Hence, there is a need to focus on two key system features - political leadership and dynamic bottom-up agency that maintains everyone's focus on the goal to be achieved, and a limitation of system constraints so that communities can shape best adapted primary care services that truly meet the needs of their individuals, families, and community.

Repeated delegation

In an ongoing relationship of delegated decision making, a principal consults a biased agent to assess projects' returns. In equilibrium, the principal allows future bad projects to reward fiscal restraint, but cannot commit to indefinite rewards. We characterize equilibrium payoffs (at fixed discounting), showing that Pareto optimal equilibria are implemented via a two-regime ‘Dynamic Capital Budget’. Rather than facing backloaded rewards—as in dynamic agency models with commitment power—the agent loses autonomy as time progresses.

Learning, belief manipulation and optimal relationship termination

We study a dynamic agency problem in which a principal and an agent interact on a project repeatedly with the agent’s ability initially unknown to both players. Because an incompetent agent generates successes less frequently and thereby needs to be rewarded more generously for his successes, the agent has attempts to “play dumb” by shirking deliberately. We show that the principal can incentivize the agent by resorting to a combination of wage payments and relationship termination. In equilibrium, relationship termination is introduced in the contracts only when the players’ assessment about the agent’s ability is above a threshold. As a result, the dynamic agency cost presents a non-monotonic relationship with the agent’s ability.

Financing a Black Box

This paper studies the implications of persistent private information on a firm's optimal financing and investment policies. In a dynamic agency model, an investor supplies capital to an entrepreneur with an opaque production technology. The investor observes neither the true productivity of the technology nor the actual amount of the output produced. The entrepreneur can generate private benefit from misreporting productivity and diverting output, both of which bear a persistent negative effect on the long-term growth of the technology. In contrast to the predictions of standard investment models, the persistence of the agency friction rationalizes overinvestment especially among firms with a strong history of cash flow but a low Tobin's q, and reconciles the optimal financing policy with the empirical observations of a strong investment-cash-flow sensitivity and a weak or even negative investment-q sensitivity.

The Ratchet Effect: Theory and Empirical Evidence

We use a dynamic agency model to examine the implications of different target-setting processes for managerial incentives and for the interpretation of empirical tests used to make inferences about the ratchet effect. We assume that firms cannot commit to any specific future targets but they can commit to a process that generates future targets as a function of observed performance. Our findings suggest that commonly used empirical tests based on the target ratcheting model often falsely reject the null hypothesis of no ratchet effect. Alternative tests based on the serial correlation in performance relative to target perform better but can still lead be inconclusive about the incentive effects of target revisions. Next, we show that the ratchet effect can be identified as an effect of past performance on changes in perceived target difficulty. We use panel data from nine annual 2011–2019 surveys to implement this test. Similar to prior studies, we find strong evidence of target ratcheting in that targets are revised upward following good performance. Nevertheless, the estimation approach motivated by our model rejects the ratchet effect hypothesis because we find that good performance in one period is also associated with a decrease in perceived target difficulty in the next period.

Agency conflicts and short- versus long-termism in corporate policies

We build a dynamic agency model in which the agent controls both current earnings via short-term investment and firm growth via long-term investment. Under the optimal contract, agency conflicts can induce short- and long-term investment levels beyond first best, leading to short- or long-termism in corporate policies. The paper analytically shows how firm characteristics shape the optimal contract and the horizon of corporate policies, thereby generating a number of novel empirical predictions on the optimality of short- versus long-termism. It also demonstrates that combining short- and long-term agency conflicts naturally leads to asymmetric pay-for-performance in managerial contracts.

The emergence of sensemaking through socio-material practices

PurposeThe purpose of this paper is to increase understanding of how sensemaking occurs as a holistic, processual phenomenon during an organisational change.Design/methodology/approachA longitudinal, qualitative case study was conducted by analysing video-recorded meetings among the staff of two recently merged surgical departments in a university hospital. Sensemaking was approached through the lens of socio-material practices.FindingsThe analysis revealed that material-discursive practices produce sensemaking in various ways, creating a holistic process and a dynamic agency. Four sensemaking practices were identified through which personnel made sense of the development of ward inpatient rounding: facilitated meetings, a status board, video analysis and humour.Originality/valueThis paper identifies diverse sensemaking practices, each of which increases understanding of sensemaking as a holistic, processual phenomenon that emerges through socio-material practices. The paper also enhances practical understanding of how sense is made of a working practice, as well as how a working practice is developed and improved during an organisational change.

Real Incentive Effects of Soft Information

ABSTRACTBoth soft, noncontractible, and hard, contractible, information are informative about managerial ability and future firm performance. If a manager's future compensation depends on expectations of ability or future performance, then the manager has implicit incentives to affect the information. We examine the real incentive effects of soft information in a dynamic agency with limited commitment. When long‐term contracts are renegotiated, the rewards for future performance inherent in long‐term contracts allow the principal partial control over the implicit incentives. This is because the soft information affects the basis for contract renegotiation. With short‐term contracts, the principal has no control over the basis for contract negotiation, and thus long‐term contracts generally dominate short‐term contracts. With long‐term contracts, the principal's control over implicit incentives is characterized in terms of effective contracting on an implicit aggregation of the soft information that arises from predicting (forming expectations of) future performance. We provide sufficient conditions for soft information to have no real incentive effects. In general, implicit incentives not controllable by the principal include fixed effects, such as career concerns driven by labor markets external to the agency. When controllable incentives span the fixed effects of career concerns, the latter have no real effects with regard to total managerial incentives—they would optimally be the same with or without career concerns. Our analysis suggests empirical tests for estimating career concerns that should explicitly incorporate noncontractible information.

Dynamic Agency and Endogenous Risk-Taking

I study a continuous-time principal–agent model in which a multitasking agent engages in unobserved risk-taking. Risk-taking creates short-term profits but also increases the chance of large losses. The optimal contract incentivizes excessive risk-taking when the agent has insufficient skin in the game. Moreover, if the low effort is not too value-destroying and the private benefit of shirking is low enough, the principal can eliminate risk-taking by implementing the low effort. However, with variable project scale, addressing the risk-taking incentives by downsizing projects is not optimal. The implementation of the optimal contract shows that risk management should take agency problems into account. Complete hedging against downside risks provides incentives for the agent to gamble. This paper was accepted by Gustavo Manso, finance.

Dynamic financial contracting with persistent private information

AbstractWe study a dynamic agency model where the agent privately observes the firm's cash flows that are subject to persistent shocks. We characterize the policy dynamics and implement the optimal contract by financial securities. Because bad performance distorts investors' beliefs downward, the agent has less incentive to misrepresent information. The agent's compensation is less than what he can divert and is convex in performance. As private information becomes more persistent, (i) the agent is compensated more by stock options; (ii) firm credit limits vary more with history, dropping after bad performance; (iii) the firm is financially constrained for longer time.

A Dynamic Agency Based Asset Pricing Model with Production

We develop a general equilibrium model based on dynamic agency theory to study investment and asset prices. In our environment, neither firms nor workers can commit to compensation contracts that provide continuation values below their outside options. At the aggregate level, the presence of agency frictions amplifies the market price of risks and allows our model to generate a sizable equity premium with a low level of risk aversion. History dependent labor contracts generate a form of operating leverage and allow our model to match the key features of the aggregate and cross-section of investment and equity returns in the data. A variance decomposition of investment into discount rate news and cash flow news supports the mechanism of our model.

Leading indicator variables and managerial incentives in a dynamic agency setting

This paper studies, in a dynamic agency setting, how incentives and contractual efficiency are affected by leading indicators of firms’ future financial performance. In our two-period model, a leading indicator variable provides a noisy forecast of the uncertain return from the manager’s long-term effort, and both contracting parties cannot refrain from renegotiating contract terms based on updated information. We find that the leading indicator can reduce the manager’s long-term effort incentive, as it allows the firm owner to capture more of the resulting return through renegotiated wages (i.e., the manager is held up). By reducing the uncertainty about future aggregate cash flows, the leading indicator also exacerbates the “ratchet” effect and discourages the manager’s short-term effort. In equilibrium, as the leading indicator becomes more accurate in forecasting future cash flows, the first-period contract attaches higher explicit weights to both the forward-looking leading indicator and backward-looking cash flow, and yet the manager may find it optimal to reduce both the short- and long-term efforts. We further show that with a more accurate leading indicator variable, the explicit incentive on the lagging cash flow may increase more than that on the leading indicator, and the equilibrium firm profit may decrease and diverge from the manager’s equilibrium efforts.

Dynamic Agency and Investment Theory under Model Uncertainty

AbstractWe extend dynamic agency and investment theory by incorporating model uncertainty. As concerns regarding model uncertainty induce a trade‐off between incentives and ambiguity sharing, the principal tends to delay the cash payout to the agent. We find model uncertainty lowers the firm value, the average q and marginal q, where q is defined as the ratio between a physical asset's market value and its replacement value. Furthermore, model uncertainty leads to insufficient investment, which provides an alternative explanation for under‐investment. Finally, the optimal pay‐performance sensitivity of the agent's continuation value to the firm's output is state dependent and exceeds the lower bound when it is close to the payout boundary.

How Important Are Dismissals in CEO Incentives?: Evidence From a Dynamic Agency Model

I estimate a dynamic agency model to quantify the importance of dismissals in CEO incentives -vis-a-vis pecuniary compensation. The model features endogenous dynamics in deferred and flow compensation, as well as exogenous departures, and endogenous dismissals after poor firm performance. Thus, the model functions as a classification device for CEO turnover events that exploits information from all the departures in the data. I estimate the model via the Simulated Method of Moments, using data for CEOs in U.S. public firms appointed from 1993 to 2013. The estimated CEO dismissal rate is 1.2 percent, and the CEO replacement cost represents 3.4 percent of firm assets, 64 million in 2015 U.S. dollars for the median firm. Poor governance, proxied by director independence, increases the replacement costs for big firms. The relationship reverses in small firms, so board independence must also capture better hiring policies or career concerns of directors. The results confirm that CEO dismissals are infrequent. However, changes in the cost of replacements that generate small increases in the underlying dismissal rate lead to substantial reductions in the size of incentive compensation.

Delegated Monitoring and Contracting

In a dynamic agency model, investors finance a firm run by an agent while delegating monitoring and contracting with the agent to an intermediary. The intermediary passes through part of its incentives to the agent. After good performance, the agent's incentives create an agency overhang problem, that is, the reduced incentives of the intermediary for monitoring because its benefit accrues mostly to the agent. Conversely, after poor performance, the agent's incentives generate incentives for monitoring to avoid further distress. Investors can benefit from directly contracting with the agent to prevent propagating agency conflicts between the agent and the intermediary.

Dynamic Agency and Large‐Risk Taking

AbstractI propose a dynamic investment model with moral hazard under which greater exposure to future uncertainties about losses could enhance incentive provisions and improve firm value. The model provides an explanation for why many financial companies and investment banks choose to improve their short‐run performance by putting themselves at greater risk of catastrophic losses in the future, as what happened prior to the 2007 financial crisis.

Toward an Earthbound Theology

Abstract This article considers some metaphysical and theological implications of the Anthropocene, which is the proposed name for a new geological epoch that is characterized by massive human disturbances of the Earth system. This stratigraphic time unit concludes the Holocene epoch that offered a relatively stable climate for human civilizations to emerge and flourish. The Anthropocene therefore marks the end of such natural stabilities - both real and imagined - along with a growing awareness of the dynamic agency or subjectivity of the Earth. By magnifying nonhuman subjectivity, the new epoch is widely interpreted by scholars across a range of disciplines as unsettling modern dualistic notions of human exceptionalism. Consequently, nonhuman nature is no longer a relatively inert background for human cultural activities. Humans and nonhumans must now be seen as interrelated Earth subjects. This nonmodern perspective suggests an ecological metaphysics of intersubjectivity along the lines of Alfred North Whitehead’s philosophy of organism, which redistributes subjectivity, creativity, and transcendence throughout nature. Theology in the Anthropocene must therefore account for this nondual view of reality, which arguably implies a divine-world relation characterized by mutual immanence. The proposed earthbound theology ultimately envisions the divine as poetic exemplification of intersubjectivity.

When q theory meets large losses risks and agency conflicts

We incorporate large losses risks into the DeMarzo et al.(2012) model of dynamic agency and the q theory of investment. The large losses risks induce losses costs and losses arising from agency conflicts during the large losses prevention process. Both of them reduce firm’s value, distort investment policy and generate a deeper wedge between the marginal and average q. In addition, we study the implementation of the contract to enhance the practical utility of our model. The agent optimally manages the firm’s cash flow and treats the cash reservation and credit line as the firm’s financial slack, and hedges the productivity shocks and large losses shocks via futures and insurance contracts, respectively.