First-best Level Research Articles

Monopolistic Competition and Efficiency under Firm Heterogeneity and Nonadditive Preferences

We consider the single-sector version of the Melitz-Ottaviano model of monopolistic competition with heterogeneous firms. We characterize the first-best and market allocations. We find that the market provides the first-best level of entry but too little selection; hence, the market provides too many varieties and too little aggregate quantity, and allocates too little (much) production to low (high) cost realizations. Allowing for a broad family of quantity allocation functions, we establish sufficient conditions for the global optimality of the first-best solution. Several important extensions are also examined. (JEL D21, D43, D50, D60)

Will you stick to a high-quality collecting standard? order fulfillment vs. limited supply in diseconomy-cost-mattered remanufacturing operations

Consider a remanufacturing system consisting of a brand, a new component supplier (Supplier N), and a remanufactured component supplier (Supplier R). The brand priorly purchases remanufactured components and then assembles them into final products, while Supplier R collects the end-of-life products with random residual quality and then produces them to be “as good as new” components at a diseconomy cost based on the residual quality. Supplier R has the option to provide order fulfillment commitment before production (Scenario O), or, do not provide such a commitment, reserving the right to limit the proportion of the orders to save production costs although it may drive the brand to emergently purchase the new components (Scenario L). Specifically, in Scenario L, Supplier R can set a strict residual quality standard which saves the remanufacturing cost and constrains the brand’s order quantity. We reveal that constraining the brand’s order quantity will not be the optimal choice for Supplier R, because the overreliance on the limited-supply threat will distort Supplier R’s wholesale price decision, resulting in significant profit loss. However, the supply chain system can perform better with the quantity constraint, because it concentrates the channel power in the hands of a single decision maker, which enables the decisions made more closely to the first-best level.

Optimal subsidization for the adoption of new irrigation technologies

Cost-sharing subsidies partially cover the fixed costs of water-saving technologies, promoting their adoption as one of the major irrigation water demand management tools that improve on-farm irrigation system efficiency and potentially free up more water for higher-value uses in water-scarce areas. In this study, we investigate the optimal subsidization scheme in the presence of adverse selection problems where the farmer’s wealth is her private information using a theoretical model of a centralized regulatory structure. In the model, we show that the first-best investment levels can be implemented when the regulator has enough resources for subsidization. Otherwise, the outcome depends on which farmer – the high-wealth farmer or the low-wealth one – contributes more to the social welfare when confronted with their first-best investment levels. Particularly, the model’s findings suggest that an optimal subsidization scheme might involve either high or low wealth farmer’s investment level being downward distorted from their first-best levels. Furthermore, in some circumstances, if the wealth disparity is sufficiently large, it is optimal to subsidize high wealth farmers only. Overall, prioritizing economic efficiency may help conserve scarce irrigation water, but it may also conflict with social equity by denying some farmers access to public subsidies.

Policies to Promote Carbon Capture and Storage Technologies

AsbstractWe model the value chain of Carbon Capture and Storage (CCS) by focusing on the decisions taken by actors involved in either capture, transport or storage of CO2. Plants emitting CO2 are located apart. If these invest in carbon capture facilities, the captured CO2 is transported to terminals, which again transport the received amount of CO2 to a storage site. Because of network effects, we may have three equilibria: one with no CCS, one with low investments in CCS, and one with high investments in CCS. In a numerical specification of the model, we find that the market for CCS may be in a state of excess inertia, i.e., even if the social cost of carbon is sufficiently high to justify investment from a social point of view, the market actors may not succeed in coordinating their efforts to reach the equilibrium with high investment. The government should then consider offering economic incentives to investments. In addition to the network effect, several other market imperfections exist, such as market power, economics of scale and the environmental externality from CO2 emissions. We identify policy instruments—in addition to a correctly set carbon tax—that will correct for the remaining market imperfections and bring private investments in line with the first-best levels. Without correction, too many terminals are set up and too few plants invest in capture facilities in our reference market structure.

Attraction versus Persuasion: Information Provision in Search Markets

We consider a model of oligopolistic competition in a market with search frictions, in which competing firms with products of unknown quality advertise how much information a consumer’s visit will glean. In the unique symmetric equilibrium of this game, the countervailing incentives of attraction and persuasion yield a payoff function for each firm that is linear in the firm’s realized effective value. If the expected quality of the products is sufficiently high (or competition is sufficiently fierce), this corresponds to full information: firms provide the first-best level of information. If not, this corresponds to information dispersion: firms randomize over signals.

Contractual flexibility, firm effort, and subsidy design: A comparison of PPP project contracts

A growing number of infrastructure projects in developing countries are being provided by private firms through public-private partnership (PPP). We compare rigid and flexible contracts for PPP projects under demand uncertainty, the former of which is not allowed to be adjusted through renegotiation when demand uncertainty materializes while the latter is. In comparing the rigid and the flexible contracts, we highlight their respective strengths of inducing firm effort and adaptation to the uncertainties. We present clear conditions under which each contract type can lead to better performance, measured by firm effort, firm profit, and consumer surplus. We have further investigated the effects of government subsidies on the comparison results. We show that government subsidies are able to improve the comparative advantages of the flexible contract, regardless of subsidy forms. The effects of different government subsidies in improving firm effort to the first-best level under the two contract types are also analyzed.

Robust contracting and corporate-termism

We build a robust contract model in which the principal is ambiguity averse regarding the distribution of transitory and permanent shocks. Short-term and long-term investments are at the discretion of the agent. We find that ambiguous transitory shocks generate pessimism concerning earnings in the short run, while ambiguous permanent shocks can lead to optimism about the long-run growth rate. Since short-run pessimism mitigates agency costs, the short-term investment rises beyond the first-best level, leading to short-termism. In contrast, long-run optimism exacerbates the cost of incentive provision and reduces the long-run investment below the first-best level. Finally, in a robust contract, a negative correlation between transitory and permanent shocks can both amplify and mitigate corporate short-termism.

On the money creation approach to banking

We study today’s two-tier money creation and destruction system: Commercial banks create bank deposits (privately created money) through loans to firms or asset purchases from the private sector. Bank deposits are destroyed when households buy bank equity or when firms repay loans. Central banks create electronic central bank money (publicly created money or reserves) through loans to commercial banks. In a simple general equilibrium setting, we show that symmetric equilibria yield the first-best level of money creation and lending when prices are flexible, regardless of monetary policy and capital regulation. When prices are rigid, we identify the circumstances in which money creation is excessive or breaks down and the ones in which an adequate combination of monetary policy and capital regulation can restore efficiency. Finally, we provide a series of extensions and generalizations of the results.

Intermediation in reward-based crowdfunding: a cash deposit mechanism to reduce moral hazard

A major impediment to crowdfunding is the unobservable actions initiated by an entrepreneur, which generally results in moral hazard. This study aims to demonstrate how an online intermediary, functioning as a crowdfunding platform, can reduce the moral hazard problem by designing a cash deposit mechanism. A model that illustrates the relationship among a crowdfunding platform, an entrepreneur and various consumers is built. With crowdfunding, an entrepreneur can ask a large audience to back up his/her project with money and then reward each funder with a product. The quality of the product depends on the combined effort of the entrepreneur and pure luck. Our results show that for projects with a high marginal cost of effort and low difference in quality, the crowdfunding platform tends to set a high compensation ratio and implement strict control of the starting capital. The crowdfunding platform prefers projects with a low marginal cost of effort and high difference in quality due to the higher amount of financing. The major findings indicate that crowdfunding platforms can reduce moral hazard by setting up a cash deposit mechanism. However, this mechanism exhibits limitations in projects with high fixed costs, that is, the effort cannot reach the constrained first-best level. For projects with a high marginal cost of effort or low difference in quality, this mechanism will reduce social welfare.

Heterogeneity in Farmers\u2019 Social Preferences and the Design of Green Payment Schemes

We examine how social preferences affect the workings of voluntary green payment schemes and show that a regulator could use facilitation services along with a social reward to generate better ecological outcome at less cost by exploiting a farmer’s social preferences to gain a green social-image/reputation. To motivate our model, we first present the results of an incentivized elicitation survey in Scotland which shows that there is a social norm of biodiversity protection on private land among farmers. Moreover, the results of a discrete choice experiment reveal that farmers are willing to give up economic rents for more publicity of their conservation activities; this confirms the relevance of reputational gain in the context of green payment schemes. Our model assumes two types of farmers, green and brown, with a green farmer taking more biodiversity protection actions than a brown farmer. We design a menu of contracts that offers both monetary incentives and non-monetary incentives (a facilitation service with social reward) to induce both type of farmers to join the scheme and to exert first-best levels (i.e., symmetric information levels) of action. Results show that under asymmetric information the regulator can implement the symmetric information equilibrium levels of biodiversity protection actions with only non-monetary incentives for the green farmer and only monetary incentives for the brown farmer. This implies that a regulator can ensure better environmental outcomes, at a lower cost, by exploiting farmers’ social preferences and by offering non-monetary incentives.

Specific capacity investment in supply chains

In a supply chain composed of a supplier and a buyer, the supplier must make two decisions, buyer-specific capacity and cost-reduction investment for each unit of the installed specialized capacity, before demand uncertainties have been resolved. However, because capacity is not verifiable, the firms cannot commit to firm contract terms. Bearing the upfront investment cost, the supplier under-builds specific capacity and under-invests in the cost-reduction innovation, thereby lowering supply chain efficiency. A common arrangement is that the parties agree to some initial contract terms ex ante, and may renegotiate ex post. This paper investigates whether several common types of contract can induce the supplier to build specialized capacity and invest in cos-reduction innovation at the first-best levels, and how ex post renegotiation affects the results. Under quantity-only contracts, the supplier will over-invest in cost-reduction innovation but under-build specific capacity either with or without ex post renegotiation. Under price-only contracts, the supplier will under-invest in cost-reduction innovation but over-build specific capacity. Ex post renegotiation improves the channel profit and brings the supplier’s decisions closer to the firstbest, but its decisions remain suboptimal. However, there exist one quantity-plus-price initial agreement and a schedule of option contracts that yield the first-best decisions. The price/quantities do not change whether ex post renegotiation is permissible. However, channel efficiency and the firms’ profits improve when ex post renegotiation is permissible. Because of the flexibility of option contracts, the firms renegotiate only if the buyer exercises up options and wants to buy more ex post, while they renegotiate with certainty under the optimal quantity-plus-price initial contract.

The Effects of Temporal Distance on Intra-Firm Communication: Evidence from Daylight Savings Time

Cross-border communication costs have plummeted and enabled the global distribution of work, but frictions attributable to distance persist. We estimate the causal effects of temporal distance stemming from time zone differences on intra-firm communication. We argue that temporal distance reduces synchronous and impromptu communication from first-best levels, and presents an especially costly friction for knowledge-intensive work. Exploiting detailed data from a large multinational firm and discrete changes in temporal distance due to shifts to and from Daylight Savings Time, we show that office pairs that lose one or two shared business hours due to DST reduce their total communication volumes by 9.2 percent on average from baseline levels, an effect driven by decreases in scheduled calls & meetings (-10.7 percent) and in instant-message chat volumes (-8.7 percent). When office pairs gain one or two shared business hours, volumes of unscheduled calls increase (+17.6 percent). Volumes of asynchronous communication (e-mail), in contrast, show no significant responses to changes in temporal distance. Examining heterogeneity by employee function, we find evidence that the shadow value of additional shared time is higher for knowledge-intensive (RD however, such adjustments do not fully offset lost communication during business hours. We discuss the implications of our findings for distributed work and for firms’ spatial organization.

Overexploitation Risk in “Green Mountains and Clear Water”

This study is motivated by a real project in China in the context of “Green Mountains and Clear Water”. As pointed out by Xi (2016), “to improve the environment is to boost productivity”. The purpose of this paper is to devise optimal capital allocation and compensation mechanisms when there exist social and environmental responsibility risks. A firm with access to a single investment project in an ecoregion may engage in environmental violations, and the ecoregion's proprietor (say municipal government) with preferences for ecological protection privately observes the process audit effort level. I extend the contract theory to a more general setting and find that given linear compensation schemes, the optimal solution is to set the non-negative share of project cash flows larger than 100% while the fixed component negative. The incentive-compatible mechanism gives rise to the overinvestment and overexploitation problems relative to the first-best level, and both problems become smaller as process audit effort level increases. Finally, I investigate how the model may vary with relevant characteristics such as multi-resource requirement, risk-averse government, and verifiable process audit information. Given unverifiable process audit information, municipal government faces a dilemma of gaining a higher compensation but losing a larger ecological area. In such a case, municipal government has to seek a compromise and may pin hopes on higher audit effort levels from superior administration units. The analysis also highlights the power of stricter process audit to reduce market surplus loss caused by information asymmetry.

Knowledge Transfer, Transitional Dynamics and Optimal Research & Development Policy in a Dynamic Monopoly Setting

This paper focuses on the question of whether or not a reduction of the knowledge barrier is good for welfare. Based on a dynamic monopoly setting with simultaneous investment decisions in process as well as in product Research & Development (R&D), we show that a reduction of the knowledge barrier has ambiguous welfare consequences: due to a lower knowledge barrier, product quality and welfare increase in the short-run. However, this may not necessarily be the case in the long-run. One reason is that a positive long-lasting knowledge barrier shock triggers the monopolist sub-optimally to reduce its product R&D investments today and in the future at the cost of future product quality. This in turn may reduce welfare. Accordingly, to realize the first-best level of product quality, the long-run optimal R&D subsidy rate for product innovations increases with a reduction of the knowledge barrier.

Thorstein Veblen, Joan Robinson, and George Stigler (Probably) Never Met: Social Preferences, Monopsony, and Government Intervention

Wages and employment are too low in a monopsony. Furthermore, a minimum wage or a subsidy may raise employment up to its first-best level. First, we analyze whether these important predictions still hold if workers compare their income to that of a reference group. Second, we show that the undistorted, competitive outcome may no longer constitute the benchmark for welfare comparisons. Third, we derive a condition which guarantees that the monopsony distortion is exactly balanced by the impact of social comparisons. Finally, we show how wage restrictions and subsidies or taxes can be used to ensure this condition both for a welfarist and a paternalistic welfare objective.

The impact of carbon emissions tax on vertical centralized supply chain channel structure

This paper studies the supply chain channel structure which is considered choosing either centralization or decentralization in both a single chain system with a single product and a two chains system with competition in the two substitutable products under carbon emissions tax, respectively. In the two cases, each chain consists of a retailer, who acts as a follower and a manufacturer who acts as a leader. Our analytical results show that: (i) When decentralization is practicable, the government is willing to set a lower carbon tax. (ii) In a single-chain system, the monopolistic manufacturer is better off under decentralization than under centralization when its product emissions pollution is high enough. (iii) In the two chains system, two manufacturers can benefit from decentralization when their product is more emissions polluting. Under certain conditions, comparing with centralization, decentralization enhances two manufacturers’ profits through carbon emissions tax reduction and keeps consumer surplus and social welfare at the first-best level. (iv) The manufacturer’s product quantity under decentralization is lower than that under centralization due to double marginalization effect, which also results in the lower environmental pollution. Our study also suggests that for the seriously emissions polluter, when it utilizes decentralization, the government have to introduce a lower carbon emissions tax in the consideration of abating environmental pollution and of maximizing its profits. The result can also benefit policy-makers in instructing firms to choose decentralization for promoting social development and environmental protection.

Contract design for equipment after-sales service with business interruption insurance

After-sales service is strategically important for mission-critical equipment due to the high operational risks involved (e.g., machine breakdowns). To address this challenge, the operators of such equipment often purchase business interruption (BI) insurance to mitigate operational risks. In this paper, we develop a principal-agent model to study an after-sales service contracting problem with an insurance option. Two prevailing contract forms are considered: a resource-based contract (RBC) and a performance-based contract (PBC). We first show that, in the presence of insurance, a PBC outperforms an RBC in terms of system performance due to the skewed incentives inherent in an RBC. More important, our results show that insurance plays contrasting roles in incentivizing a service supplier under the two contracting mechanisms. Under an RBC, insurance improves the service supplier’s effort provision and hence benefits the operator because insurance provides a risk-sharing mechanism that better aligns the incentives of the service supplier and the operator. Under a PBC, although the supplier’s equilibrium effort remains at the first-best level regardless of the insurance coverage level, the use of insurance changes the operator’s optimal contract and the risk allocation between the operator and the supplier. Our findings provide important insights into the interplay of insurance and contract incentives in an after-sales service context.

Peace keeping in a model of conflict with foreign investments

PurposeThis paper aims to examine the role of outside peacekeepers in a bilateral conflict.Design/methodology/approachThe authors build upon a trade theoretic framework by incorporating disruptions due to war, which could affect directly the return to investment, both domestic and foreign, and by introducing explicitly peacekeeping forces into the model. Two countries are engaged in a war, with the purpose of capturing capital. A third country plays a dual role: it is the source of investments in the warring countries, and it deploys soldiers on ground for peacekeeping purposes. The authors consider the cases where the levels of foreign investments are exogenous and when they are endogenously determined by free mobility conditions. In the worst case, they find that foreign investment reduces conflict. In the case of endogenous foreign investments, they examine the effect of multilateral agreements where the two warring countries reduce their number of soldiers and the third increases the number of peacekeepers.FindingsThe authors find that the reform benefits all three countries and increases the level of foreign investments. They consider the cases of exogenous and endogenous foreign direct investment (FDI). In the first case, the authors examine the effect of an exogenous increase in FDI on the war equilibrium and find that it reduces the employment of soldiers in the warring countries and increases the size of the peacekeeping force. They also find that the first-best level of peacekeeping is larger than the equilibrium level. When FDI is endogenous, starting from the initial war equilibrium, they also examine the effect of a multilateral agreement in which the size of the peacekeeping force is increased by the third country and the two warring countries agree to reduce their war efforts. The authors find that the reform makes all three countries better off and increases the level of FDI.Originality/valueThe paper uses a theoretical model with third-party interventions in a bilateral war. It intends to shed light on some of the missing economic implications of peacekeeping. The paper introduces explicitly peacekeeping forces into the analysis and introduces a factor that represents a disruption to return on investment in both warring countries. The third country has a dual role; it provides investments in the warring countries and deploys soldiers for peacekeeping. Peacekeeping reduces the disruption mentioned above and affects the employment of soldiers by the warring countries. The authors find that a multilateral agreement in which the two warring countries reduce their war efforts and the third party increases its peacekeeping force can increase welfare in all three countries.

The power of regulatory regimes reexamined

The literature finds that pure price cap regulation (PCR) is a high-powered regulatory regime because it elicits the first-best level of cost-reducing effort. Conversely, the regulated firm underinvests in cost-reducing effort under PCR with earnings sharing. These findings, while standard in the literature, do not consider the strategic behavior of the regulator ex post. When the regulator controls competitive entry and the Hope standard applies the regulated firm is no longer the residual claimant for its efficiency gains even under pure PCR. The findings of the literature are reversed in this setting. The power of the regulatory regime may be higher under PCR with earnings sharing than under pure PCR. In fact, over a wide range of welfare weights, equilibrium investment in cost-reducing effort is zero under pure PCR. This may explain why the empirical evidence on the efficiency gains from PCR falls short of an unequivocal validation of the theory.

Incentives for RFID adoption with imperfect read rates: Wholesale price premium versus cost sharing

We consider a supply chain system consisting of a manufacturer and a retailer who requires RFID technology to eliminate inventory misplacement errors. The demand is uncertain and RFID read rates are imperfect. To better align their incentives, the manufacturer can make up her additional cost stemmed from RFID adoption through two compensatory schemes: Wholesale price premium (PR) and cost sharing (CS). Our analysis shows that under PR, the manufacturer surcharges a premium higher than the tag cost, whereas under CS, the retailer will bear the entire tag cost. Because profit margin is proportionally allocated to the firms at the same ratio under PR and without RFID at the break-even point, their incentives to adopt RFID under PR are perfectly aligned. Surprisingly, under CS, further increase in RFID read rates can benefit the retailer but hurts the manufacturer. Further, the manufacturer prefers PR, whereas the retailer prefers CS when the tag cost is small; but both prefer PR when the cost is medium. Contrary to previous findings, the retailer’s incentive for RFID adoption under CS is stronger than the first-best level; the reverse is true for the manufacturer. Finally, CS improves the supply chain efficiency over PR but cannot coordinate the chain.