Optimal Contract Design Research Articles

Optimal Contract Design for Joint User Association and Intercell Interference Mitigation in Heterogeneous LTE-A Networks With Asymmetric Information

We study the problem of joint user association and intercell interference (ICI) mitigation in heterogeneous long-term evolution advanced (LTE-A) networks, presuming the absence of the precise global channel state information (CSI). We confront this problem from a contract-theoretic perspective and model the considered network as a labor market where the LTE evolved NodeBs (eNBs) are regarded as the employers offering a contract to the employees (cellular users). We explore a scenario where the wireless channels are ordered into different types according to their link gains and the cost of power consumption. It is assumed that each user knows the type of its channel but is not aware of the types of the channels belonging to other users. Hence, the channel type is regarded as the private information which is known only by the corresponding user. Under the presence of such asymmetric information, the eNBs formulate the optimal contract given by a set of the contract items (the combinations of user association, allocated spectrum, and power) and pass these items to the users, who then select the best contract items according to their channel types. The performance of a proposed contract-based resource allocation mechanism has been evaluated using the OPNET-based simulations. It has been demonstrated that the efficiency of a contract-based mechanism with asymmetric information is close to the optimal method (where the network resources are allocated based on the precise CSI). It has also been shown that the contract-based method outperforms the other relevant resource allocation techniques in terms of the total network service rate and signal-to-noise ratio.

Monitoring strategy for relay incentive mechanism in cooperative communication networks

Cooperative communication is a promising technique to improve wireless network’s capacity and resource management’s efficiency. However, due to the limited wireless network resource, the potential selfish relay nodes may not be willing to cooperate without any extra incentives. In this paper, a contract-based relay incentive mechanism is investigated under the dual asymmetric network information scenario. The optimal contract design is proposed to achieve the twin objectives of ability-discrimination and effort-incentive. Considering the feature of asymmetric information, the various monitoring strategies are designed by introducing a monitoring node. The optimal contract designs with the information-monitoring and the action-monitoring strategies are presented. Simulation results show that the optimal contract design effectively incentivizes relay nodes’ participation, and the performance of the action-monitoring strategy yields a significant enhancement compared with the non-monitoring and the information-monitoring strategies.

Contract design for relay incentive mechanism under dual asymmetric information in cooperative networks

Cooperative relay network can effectively improve the wireless spectrum efficiency and extend the wireless network coverage. However, due to the selfish characteristics of wireless nodes, spontaneous cooperation among nodes is challenged. Moreover, wireless nodes may acquire the different network information with the various nodes’ location and mobility, channels’ conditions and other factors, which results in information asymmetry between the source and relay nodes. In this paper, the incentive issue between the relay nodes’ cooperative service and the source’s relay selection is investigated under the asymmetric information scenarios. By modeling cooperative communication as a labour market, a contract-theoretic model for relay incentive is proposed to achieve the twin objectives of ability-discrimination and effort-incentive. Considering the feature of asymmetric information, the static and dynamic information of the relay nodes are systematically discussed. To effectively incentivize the potential relay nodes to participate in cooperative communication, the optimization problems are formulated to maximize the source’s utility under the multiple information scenarios. A sequential optimization algorithm is proposed to obtain the optimal wage-bonus strategy with the low computational complexity under the dual asymmetric information scenario. Simulation results show that the optimal contract design scheme is effective in improving the performance of cooperative communication.

Social Risk and the Dimensionality of Intentions

Previous research has documented a behavioral distinction between “social risk,” or risk caused by human factors, and natural risk. In particular, people tend to demand a premium on the probability of a favorable outcome in order to expose themselves to a social source of risk rather than a natural source of risk. Several explanations for what drives this social risk premium have been offered—most prominently, (i)an aversion to a counterparty’s potentially malign intentions and (ii) a more general aversion to ceding control to someone with conflicting interests. We propose that a fundamental determinant of the social risk premium may relate to a counterparty’s capacity to engage in intentional action. We employ a between-subjects experimental design in which we manipulate subjects’ capacity for intentional action. Our design allows us to identify the component of the social risk premium related to an aversion to betrayal, independent of any aversion to ceding control. Furthermore, our results show that intentions are a crucial determinant of the social risk premium. We identify factors that eliminate, and may even change the sign of, the social risk premium. Our results contribute to our understanding of the factors that influence the perception of social risk and have implications for optimal contract design in a wide variety of situations involving social risk. The online appendix is available at https://doi.org/10.1287/mnsc.2016.2694 . This paper was accepted by Uri Gneezy, behavioral economics.

Incorporating model uncertainty into optimal insurance contract design

In stochastic optimization models, the optimal solution heavily depends on the selected probability model for the scenarios. However, the scenario models are typically chosen on the basis of statistical estimates and are therefore subject to model error. We demonstrate here how the model uncertainty can be incorporated into the decision making process. We use a nonparametric approach for quantifying the model uncertainty and a minimax setup to find model-robust solutions. The method is illustrated by a risk management problem involving the optimal design of an insurance contract.

Double-sided moral hazard, information screening and the optimal contract

Purpose In the practice of venture capital investment, the venture capital will not only claim the share of the enterprise’s future output, but also a certain amount of fixed income. The purpose of this paper is to examine the optimal contract which blends the variable ownership income and the fixed income theoretically so as to provide a keen insight into the venture capital practice. Design/methodology/approach This paper establishes an extended principal-agent model and researches on the design of optimal contract dominated by venture capital with double-sided moral hazard and information screening. Findings By establishing theoretical models, the main findings are: first, high-quality enterprise tends to relinquish less ownership but give more fixed return to the venture capital as compensation in order to obtain the venture capital financing; second, low-quality enterprise is willing to relinquish more ownership but give less fixed return to the venture capital for financing; third, due to the existence of double-sided moral hazard, neither of the venture capital and the enterprise will exert their best effort. Originality/value This paper furthers the application of principal-agent model in the field of venture capital investment and researches on the optimal contract, considering double-sided moral hazard and adverse selection at the same time originally.

Model of Optimal Contract Design on Credit Default Swaps

In this paper we examine the moral hazard of credit derivatives that made them the roll boosters of the financial crisis, and develop a model of optimal contract design on credit default swap transaction to review the function of the financial instruments and the optimal contract aiming to control the moral hazard. The research presents that credit default swap transaction can optimize allocation of the credit risk, improve the bank’s return, and expanse channels of the investors. However, it reduces the bank’s efforts of monitoring credit assets, which accumulates and increases credit risks. By introducing the partial protection mechanism, we obtain an optimal contract which could effectively control the moral hazard.

Incentive Mechanisms for Cooperative Wireless Networks with Adverse Selection and Moral Hazard

Cooperative communication is a promising technique to improve utilization of the wireless spectrum resource. However, due to the limited wireless network resource, the selfish relay nodes may be unwilling to offer their relay help without any extra incentive. In this work, we study a contract-based mechanism for incentivizing cooperative relay in the presence of the dual asymmetric information. By modelling multi-user cooperative relay as a labour market, a principal-agent model is proposed with the combination of relay power, basic wage and relay bonus in the continuous type scenario. And an optimization problem of multi-user relay incentive is formulated to achieve the twin objectives of ability-discrimination and effort-incentive. Numerical results show that the optimal contract design scheme is effective in improving the performance of cooperative communication.

Optimal Reinsurance with Heterogeneous Reference Probabilities

This paper studies the problem of optimal reinsurance contract design. We let the insurer use dual utility, and the premium is an extended Wang’s premium principle. The novel contribution is that we allow for heterogeneity in the beliefs regarding the underlying probability distribution. We characterize layer-reinsurance as an optimal reinsurance contract. Moreover, we characterize layer-reinsurance as optimal contracts when the insurer faces costs of holding regulatory capital. We illustrate this in cases where both firms use the Value-at-Risk or the conditional Value-at-Risk.

Cooperative Spectrum Sharing in Cognitive Radio Networks: A Centralized Contracted-Based Approach

In this paper, we study the relay-based communication schemes for cooperative spectrum sharing among multiple primary users (PUs) and multiple secondary users (SUs) with incomplete information. Inspired by contract theory, we model the network as a labor market. In this market, PUs and SUs are regarded as employer and employee respectively. Each PU proposes certain contracts to attract the SUs, the contract include relay power and spectrum access time, each SU maximize its utility by selecting the most suitable contract. But PUs and SUs have conflicting objectives in contract content. To tackle this problem, we put forward to a centralized maximizing expectation utility scheme, which convert the optimal contract design into an optimization problem. After that, a approximate method for solving the optimization problem is proposed. Simulation results show that the losses of PUs’ total utilities caused by incomplete information and approximate algorithm are relatively small, especially when the number of SUs is very large.

Optimal contract design in the joint economic lot size problem with multi-dimensional asymmetric information

Previous work has studied the classical joint economic lot size model as an adverse selection problem with asymmetric cost information. Solving this problem is challenging due to the presence of countervailing incentives and two-dimensional information asymmetry, under which the classical single-crossing condition does not need to hold. In the present work we advance the existing knowledge about the problem on hand by conducting its optimality analysis, which leads to a better informed and an easier problem solution: First, we refine the existing closed-form solution, which simplifies problem solving and its analysis. Second, we prove that Karush–Kuhn–Tucker conditions are necessary for optimality, and demonstrate that the problem may, in general, possess non-optimal stationary points due to non-convexity. Third, we prove that certain types of stationary points are always dominated, which eases the analytical solution of the problem. Fourth, we derive a simple optimality condition stating that a weak Pareto efficiency of the buyer’s possible cost structures implies optimality of any stationary point. It simplifies the analytical solution approach and ensures a successful solution of the problem by means of conventional numerical techniques, e.g. with a general-purpose solver. We further establish properties of optimal solutions and indicate how these are related with the classical results on adverse selection.

Asymmetric Information in Frictional Markets for Liquidity: On the Non-Equivalence of Credit and Sale

The aim of this paper is to identify an optimal contract design for institutions exchanging liquidity bilaterally in an economy with an asset market subject to asymmetric information. Within a search-theoretic dynamic general equilibrium model, we establish a non-equivalence between collateralized credit and immediate settlement (an outright sale) and show through a signaling game with Perfect Bayesian equilibra, why depositing assets as collateral is a dominant strategy. In addition, we provide a compelling reason why banks apply haircuts to securities offered as collateral (over-collateralization), which justifies the observed behavior of banks on the over-the-counter market for liquidity since the eruption of the global financial crisis.

Optimal choice of capacity, toll and government guarantee for build-operate-transfer roads under asymmetric cost information

The private provision of public roads via the build-operate-transfer (BOT) mode has been increasingly used around the world. By viewing a BOT contract as a combination of road capacity, toll and government guarantee, this paper investigates optimal concession contract design under both symmetric and asymmetric information about the marginal maintenance cost of private investors. Under asymmetric information, the government guarantee serves as an instrument to induce a private investor to reveal his true cost information. Compared with the situation under symmetric information, the government will suffer a loss of social welfare; the private investor will charge a higher toll that increases in his reported marginal maintenance cost, and specify a lower capacity that decreases with the reported cost. The results also show that the private investor obtains extra information rent beyond the reservation level of return and the rent decreases with his reported cost. However, the resulting volume-capacity ratios of the BOT road under both information structures are the same.

Optimal Contracting in Networks

We study optimal contracting between a firm selling a divisible good that exhibits positive externality and a group of agents in a social network. The extent of externality that each agent receives from the consumption of neighboring agents is privately held and is unknown to the firm. By explicitly characterizing the optimal contract when the utilities are quadratic, we demonstrate how inefficiency in one agent’s trade propagates through the network and creates unequal, downward distortion in other agents’ trades. We further characterize the effect of propagation of the distortion on the firm’s profit in terms of agents’ influence and centrality in the network. We identify influential agents whose inefficiencies incur maximum loss on the firm’s profit. By explicitly solving for the simpler yet suboptimal bilateral contracts, we characterize the optimality gap between these and multilateral contracts in terms of the underlying network structure. When the network is balanced in the sense of homogeneity of influences, we show that the network structure will have no impact on the firm’s profit when contracts are bilateral. On the other hand, when the influences are heterogeneous and have high dispersion (as in star-like networks) we show that the restriction to bilateral contract can result in profit losses that grow unboundedly with the size of the network. Our result highlights the role of influential agents and network structure in design of optimal contracts and determines when knowledge of the network structure is beneficial to the firm.

Design of Regulatory Contracts – Example of the Urban Transport Industry

The present article discusses economic issues related to the design of optimal regulatory contracts on the example of the urban public transport industry. It highlights the importance of the design of efficient regulatory contracts in the context of changes facing the urban transportation industry in the European Union. Furthermore, it provides an overview of the main issues put forward in economic literature related to the design of regulatory contracts. It discusses several problems relevant in this context such as informational asymmetries, transaction costs, and regulatory capture. It also comments on a selection of views presented in economic literature dealing with these issues. Finally, the article presents the regulatory framework, contractual practices and characteristics of the French urban public transport industry. France is well known for its long standing tradition of contracting between the State and the private sector in transportation. The analysis of the French example may help to prove useful insights in this regard.

Privacy preservation in location-based advertising: A contract-based approach

Location-based advertising (LBA) is rapidly developing with the surging popularity of mobile devices and the advances in localization techniques. However, many LBA applications aggressively collect users’ location data without providing clear statements on the usage and disclosure strategies of such sensitive information, which raises severe privacy concerns. Existing privacy preservation mechanisms normally require modifications at the user side or provide limited protection. To overcome these limitations, we propose an LBA system to leverage insensitive users to broadcast location-based ads to the privacy-sensitive users around them. To reward the privacy-insensitive users for delivering the ads, we design a number-reward contract scheme, in which a set of ad broadcast reward plans is offered to different insensitive users that select the most suitable plans based on their utilities. In addition, we derive optimal contract designs in both complete and incomplete information scenarios. Simulations are carried out to verify the theoretical analysis. The results show that a win-win situation is achieved, where every entity involved has an increased utility.

Contract designs for energy-saving product development in a monopoly

We discuss two types of contracts for energy-saving products in a monopoly with the government’s budget constraint. These contracts specify the subsidy, either a fixed amount (referred to as F-type contracts) or a discount (referred to as D-type contracts), and the threshold of the energy consumption level of products, below which the products are labeled as certified products and qualified for the subsidy. We model a three-stage game and give optimal design of the contracts under two different objectives of the government: minimizing the total energy consumption and minimizing the average energy consumption. Our results show that: 1) The optimal contract designs are the same under the two objectives; 2) If the subsidy budget is relatively low, the F-type contract is more preferable than the D-type contract, and vice versa; 3) The contracts’ function of certification enables the government to take the advantage of the consumer environmental awareness to improve the environmental performance even when the government’s subsidy budget is zero; 4) Both contracts benefit the environment. Under the F-type contract, only the government pays for the environmental improvement. In contrast, under the D-type contract, both the government and consumers pay.

CEO Risk‐Taking Incentives and the Cost of Equity Capital

AbstractIn this paper, we show that the sensitivities of an executive's wealth to changes in stock prices (deltas) decrease the implied cost of equity capital while the sensitivities of an executive's wealth to changes in stock volatility (vegas) increase the implied cost of equity capital. Our findings demonstrate that shareholders understand the risks of firms’ future projects as embedded in executive compensation and price these risks into the cost of equity capital accordingly. The findings have strong implications for optimal executive compensation contract design, project evaluation and cost of capital estimation.

Optimizing maintenance service contracts through mechanism design theory

This paper presents a novel approach for designing and optimizing maintenance service contracts through the application of mechanism design theory. When offering a contract to its customer, the maintenance service provider seeks to specify contract terms – such as price, service features and incentives – that maximize the provider's profit, satisfy customer needs, allocate risks effectively and mitigate moral hazards. Optimal contract design has to account for asymmetric information and uncertainties associated with customer characteristics and behaviors. We illustrate our mechanism design approach by applying it to the contract design challenge of a gas turbine manufacturer, which also provides maintenance services for its aircraft engines. In our solution approach, we compute an optimal set of contracts. The entire set is presented to the customer and is designed such that the customer will accept one of the contract alternatives without negotiations. In addition to eliminating the costs and delays associated with negotiations, this approach also reveals the customer's private information to the service provider, which the provider can use to its benefit in maintenance management and future contract renewals. Furthermore, we design and incorporate win–win incentive mechanisms into the contracts, which reward the customer for actions that reduce maintenance costs. We present a deterministic and a stochastic mechanism design model, the latter accounting for uncertainties associated with customer actions, engine performance, and maintenance costs during the contract execution phase.

Spectrum Reservation Contract Design in TV White Space Networks

In this paper, we study a broker-based TV white space market, where unlicensed white space devices (WSDs) purchase white space spectrum from TV licensees via a third-party geo-location database (DB), which serves as a spectrum broker, reserving spectrum from TV licensees and then reselling the reserved spectrum to WSDs. We propose a contract-theoretic framework for the database's spectrum reservation under demand stochasticity and information asymmetry. In such a framework, the database offers a set of contract items in the form of reservation amount and the corresponding payment, and each WSD chooses the best contract item based on its private information. We systematically study the optimal reservation contract design (that maximizes the database's expected profit) under two different risk-bearing schemes: DB-bearing-risk and WSD-bearing-risk, depending on who (the database or the WSDs) will bear the risk of over reservation. Counter-intuitively, we show that the optimal contract under DB-bearing-risk leads to a higher profit for the database and a higher total network profit.