First-best Level Research Articles

A Hotelling Model of Fiscal Competition

This article examines a model in which two jurisdictions engage in fiscal competition. The jurisdictions’ strategic variables are labor tax rates and types of local public goods. Both are determined by majority voting. The article finds that in Nash equilibrium, labor tax rates will be efficiently chosen such that quantities of local public goods will achieve the first-best level. Furthermore, there are two symmetric Nash equilibria for the types of local public goods. These two equilibria, when they both exist, exhibit less public sector differentiation than if there were no mobility. However, a primary difference between them is that when the net gain of more population increases, in one equilibrium jurisdictions will raise the similarity of local public goods to attract population, but in the other equilibrium jurisdictions will differentiate themselves more to prevent harsh competition.

A utilitarian approach to the provision and pricing of excludable public goods

This paper studies utilitarian welfare maximization in a large economy with an excludable public good where individual preferences are private information. If inequality aversion is large, optimal allocations involve the use of admission fees and exclusion to redistribute resources from people who benefit a lot from the public good to people who benefit little. If inequality aversion is close to zero, optimal admission fees are zero. Because of inequality aversion, information rents of people who benefit a lot from the public good receive less weight, so optimal provision levels for the public good are below first-best levels.

Agency Costs in a Supply Chain with Demand Uncertainty and Price Competition

In this paper, we model a manufacturer that contracts with two retailers, who then choose retail prices and stocking quantities endogenously in a Bayesian Nash equilibrium. If the manufacturer designs a contract that is accepted by both retailers, it sets the wholesale price as a compromise between two conflicting roles: reducing intrabrand retail price competition and inducing retailers to stock closer to first-best levels (that is, optimum for the supply chain as a whole). In equilibrium, fill rates are less than first best. If, on the other hand, the manufacturer eliminates retail competition by designing a contract accepted by only one retailer, the assignment of consumers to retailers is inefficient. In either equilibrium, the performance of the supply chain is strictly less than first best. However, the manufacturer achieves first-best retail prices and fill rates if it can subsidize the retailers' leftover inventory. Absent such subsidies, the two-retailer equilibrium arises when the two retailers compete less intensively. In that equilibrium, numerical results indicate that the value of subsidizing unsold inventory is increasing in demand uncertainty, intensity of retail competition, and salvage value of inventory, and is decreasing in manufacturing cost and opportunity cost of shelf space.

Hidden information problems in the design of family allowances

We consider the optimal determination of family allowances in a model where some of the parents have higher ability to raise children than others. First-best policy gives both types of parents the same level of utility. If neither parental ability nor parental actions are fully observable, however, the policy maker has to take into account the incentive-compatibility constraint that more able parents should not find it profitable to mis-represent their true ability by investing less in their children, and having a lower number of children. The second-best policy induces more able parents to have the first-best number of children, and to invest in each child at the first-best level. Less able parents are induced to have fewer children than in first best, and will underinvest in each child. Whether the government should subsidize more the more able parents, or the less able ones, depends on the properties of the cost function. In second best, however, less able parents will end up with lower utility than more able parents whatever the cost function.

Extended liability for environmental accidents: what you see is what you get

When a firm may be bankrupted by the liability from an environmental accident, current laws often allow for the extension of liability to third parties with whom the firm contracts, with the aim of inducing full internalization of social costs. We find that, when the firm can take both observable and unobservable care to reduce expected accident damages, extended liability indeed results in full cost internalization, but not in first-best levels of care. We also find that, whereas without extended liability there is excess entry into environmentally hazardous industries, introducing extended liability leads to exit that, while excessive relative to the first best, is second-best optimal given firms' choice of care. Furthermore, we show that direct regulation of observable care, when combined with extended liability, further distorts firms' incentives. However, when used alone, such regulation strictly dominates extended liability.

Optimal Regulation of Cooperative R&D Under Incomplete Information

A regulator offers a cooperation contract to two firms to develop a research project. The contract provides incentives to encourage skill‐sharing and coordinate subsequent efforts. Innovators must get informational rents to disclose their privately known skills, which results in distorting R&D efforts with respect to the first‐best level. When efforts are strategic complements, both efforts are distorted downwards. By contrast, when efforts are strategic substitutes, the effort of the firm with most valuable skills is distorted downwards (to decrease rents) and the effort of the other firm is distorted upwards (to compensate the previous efficiency loss).

Banking Consolidation and Small Business Lending

The paper investigates small business lending as an information problem. It models the effects of information asymmetries within the bank combined with fixed wages. Two kinds of inefficiencies arise in equilibrium: the credit officer either sometimes shirks or he is occasionally fired. In both cases lending falls below the first-best level. The solution, when the bank accepts the information asymmetries, is called the centralized structure. Under decentralized structure the bank employs additional supervisors to mitigate the information asymmetries within its organization. Decentralized banks manage to finance more small firms, but incur higher costs than centralized ones. Small banks are interpreted as a bank with relatively few credit officers, whom can be monitored without information asymmetries. The specification allows for investigating the effects of banking consolidation and technological change on small business lending. The model suggests that not banking size, but organizational structure is decisive in small business lending.

Pensions with Endogenous and Stochastic Fertility

This paper studies the design of a pay-as-you-go social security system in a society where fertility is in part stochastic and in part determined through capital investment. If parents' investments in children are publicly observable, pension benefits must be linked positively to the level of investment, and payroll taxes negatively to the number of children. The outcome is characterized by full insurance with all parents, regardless of their number of children, enjoying identical consumption levels. Without observability, benefits must increase, and payroll taxes decrease, with the number of children. The second-best level of investment in children, and the resulting average fertility rate, are less than their corresponding first-best levels.

Caution, Children Crossing: Heterogeneity of Victim's Cost of Care and Negligence Rule

The paper deals with a bilateral accident situation in which victims have heterogeneous costs of care. With perfect information, efficient care by the injurer raises with the victim's cost. When the injurer cannot observe at all the victim's type, and this fact can be verified by Courts, first-best cannot be implemented with the use of a negligence rule based on the first-best levels of care. Second-best leads the injurer to intermediate care, and the two types of victims to choose the best response to it. This second-best solution can be easily implemented by a negligence rule with second-best as due care. We explore imperfect observation of the victim's type, characterizing the optimal solution and examining the different legal alternatives when Courts cannot verify the injurers' statements. Counterintuitively, we show that there is no difference at all between the use by Courts of a rule of complete trust and a rule of complete distrust towards the injurers' statements. We then relate the findings of the model to existing rules and doctrines in Common Law and Civil Law legal system.

Public-Good Provision with Many Participants

For a nonexcludable public good with benefit and cost functions independent of the number of participants, this paper studies second-best allocations under Bayesian interim incentive compatibility and interim individual rationality. As the number of participants becomes large, second-best provision levels converge in distribution to first-best levels if the latter are bounded. Second-best provision levels become large in absolute terms but small relative to first-best levels if benefit and cost functions are isoelastic. In contrast, for an excludable public good, the ratio of second-best to first-best levels is bounded away from zero.

Stock options and employees' firm-specific human capital under the threat of divestitures and acquisitions

This paper considers whether the first-best level of firm-specific human capital investment is attained by the use of stock option plans for workers and stock offers in acquisitions even though workers are threatened with the possibility of a divestiture and acquisition. We show that the first-best level of investment is achieved by a stock option plan with a positive exercise price for workers conditional on the event of a divestiture. We also suggest that, under certain conditions, a stock offer in acquisition can resolve a collusion problem between the target firm (TF) and its workers.

Stock Options and Employees' Firm-Specific Human Capital Under the Threat of Divesture and Aquisition

This paper considers whether or not the first-best level of firm-specific human capital investment is attained by the use of stock option plans for workers and the choice of the method of payment for acquisitions even though workers are threatened with the possibility of a divestiture and acquisition. We show that the first-best level of firm-specific human capital investment is achieved by a stock option plan with a positive exercise price for workers conditional on the event of a divestiture and acquisition. We also suggest that, under certain conditions, a stock offer in the acquisition can resolve a collusion problem in which the target firm may collude with workers and attempt to raise the acquisition tender price up to the level that is consistent with the first-best level of investment even though workers actually choose an inefficient level of investment.

Hidden Information Problems in the Design of Family Allowances

We consider a case where some of the parents have higher ability to raise children than others. First-best policy gives both types of parents the same level of utility. If parental actions are not fully observable, however, the policy maker has to take into account the incentive-compatibility constraint that more able parents should not find it profitable to misrepresent their true ability by investing less in their children, and having a lower number of children. The second-best policy induces more able parents to have the first-best number of children, and to invest in each child at the first-best level. Less able parents are induced to have fewer children than in first best, and will underinvest in each child. Whether the government should subsidize more the more able parents, or the less able ones, depends on the properties of the cost function. In second best, however, less able parents will end up with lower utility than more able parents whatever the cost function.

Optimal Environmental Regulation in the Presence of Other Taxes: The Role of Non-separable Preferences and Technology

Abstract Recent studies find that environmental taxes typically exacerbate pre-existing tax distortions and, therefore, the optimal pollution tax should lie below the Pigouvian level (social marginal damages). This paper analyzes a general equilibrium model with non-separable preferences and technology, relatively rare assumptions in this literature, and finds that the second-best optimal pollution tax can be above or below the first-best Pigouvian level. Surprisingly, the ordering of the two does not depend on the degree of pre-existing tax distortion. Moreover, it depends not just on the difference between the two goods' cross-price elasticities with leisure, but on that difference compared to the elasticity of demand for the polluting intermediate input. Finally, the paper shows that under plausible parameter conditions, a greater pre-existing tax distortion can increase the optimal level of environmental regulation.

Informal insurance in renewable resource harvesting

A general equilibrium model is presented where a small number of resource users share part of their harvests with each other. As the productivity of resource harvest is stochastic, the sharing rule can be interpreted as an informal insurance contract. As individual labour inputs are unobservable, an exogenous increase in the insurance premium causes individuals to expend less effort on harvesting. However, the resulting inefficiency is reduced by an increase in the expected long-run level of the resource stock. A second-best efficient level of sharing exists, which is positive but smaller than the first-best level if the resource stock per capita is small. Copyright 2002, Oxford University Press.

Strategic sharing in regulatory regimes

A firm subject to price cap regulation (PCR) disciplines the regulator’s choice of entry-accommodation rule through a convex combination of earnings and effort sharing. The first-best level of cost-reducing effort is not achieved in this model even under pure PCR.

Legal Remedies for Breach of the Regulatory “Contract”

We present a model of the regulatory “contract” that focuses on the mutual investment of buyer and seller and recognizes the cost of contractual renegotiation and the importance of breach remedies when contracts are incomplete. We model renegotiation as a litigation game played before a quasi-judicial administrative court. We find that the standard contractual remedy of expectations damages cannot implement first-best levels of investment for both buyer and seller. If the seller fully recovers its sunk investment upon buyer breach, however, then first-best levels of investment by both buyer and seller can be supported provided litigation costs are small enough.

Optimal Regional Redistribution Under Asymmetric Information

Optimal Regional Redistribution under Asymmetric Information by Massimo Bordignon, Paolo Manasse and Guido Tabellini. Published in volume 91, issue 3, pages 709-723 of American Economic Review, June 2001

Moral Hazard and Renegotiation with Multiple Agents

We investigate the effects of contract renegotiation in multi-agent situations where risk-averse agents negotiate a contract offer to the principal after the agents observe a common, unverifiable perfect signal about their actions. We show that renegotiation with multiple agents reduces the cost of implementing any implementable action profile down to the first-best level, even though the principal cannot observe the agents' actions. Moreover, it is sufficient for the principal to use a simple initial contract, in the sense that it consists of no more than a single sharing scheme for each agent and the total payments to the agents are the same regardless of the realised state. An important implication is that decentralization, in the sense of delegated negotiation and proposals from the agents, can be as effective as centralized schemes that utilize revelation mechanisms in unrestricted ways.

Sharing default information as a borrower discipline device

Creditors often share information about their customers’ credit records. Besides helping them to spot bad risks, this acts as a disciplinary device. If creditors are known to inform one another of defaults, borrowers must consider that default on one lender would disrupt their credit rating with all the other lenders. This increases their incentive to perform. However, sharing more detailed information can reduce this disciplinary effect: borrowers’ incentives to perform may be greater when lenders only disclose past defaults than when they share all their information. In some instances, by ‘fine-tuning’ the type and accuracy of the information shared, lenders can raise borrowers’ incentives to their first-best level.