Legal Environment and Contractual Choice

This paper considers contractual choice under imperfect legal systems, in particular, contracts with different timing of payment. Ex-ante payment contracts are risky for the buyer, because the seller may shirk. Ex-post payment contracts are risky for the seller, as the buyer may default. Optimal contract is solved for any given legal environment. Exchanges with lower gains from trade tend to adopt ex-post payment contracts. The seller is a better proposer than the buyer in terms of the efficiency of the proposed contract. Surprisingly, offering ex-ante payment contracts is not strictly better for the seller under any legal environment. Moreover, mixed payment contracts are also analyzed and shown to never be optimal.

A Bargaining-Based Model of Security Design

This paper studies how security design affects project outcomes. Consider a firm that raises capital for multiple projects by offering investors a share of the revenues. The revenue of each project is determined ex post through bargaining with a buyer of the output. Thus, the choice of security affects the feasible payoffs of the bargaining game. We characterize the securities that achieve the firm’s maximal equilibrium payoff in bilateral and multilateral negotiations. In a large class of securities, the optimal contract is remarkably simple. The firm finances each project separately with defaultable debt. Welfare and empirical implications are discussed. (JEL C78, D21, D86, G12, G32)

Comment on “Optimal Contract to Induce Continued Effort”

In this comment, we first use a counterexample to demonstrate that the optimal contract structure proposed in section 4 of Sun and Tian (2018) can be wrong when the two players’ discount rates are different. We then specify correct optimal contract structures, which involve generalizing the contract space to allow random termination. Numerical study with a wide range of model parameters illustrates that such a random termination only occurs sparingly in optimal contracts. Moreover, the suboptimality gap, measured by the relative improvement of the optimal contract over the best contract without random termination, is extremely small. This paper was accepted by Manel Baucells, decision analysis.

Optimal Contract for Machine Repair and Maintenance

Maintenance outsourcing is quite common in industries that rely on complex and critical equipment. Instead of investing in the maintenance facilities, firms outsource maintenance activities to specialized companies. However, it may be hard for firms (i.e., principal) to observe whether maintenance companies (i.e., agent) put sufficient resources into providing the best service, which gives rise to agency issues. In a dynamic environment in which an agent is responsible for both maintenance and repair of a critical machine, how the principal uses payments and termination to tackle agency issues is a challenging problem. In “Optimal Contract for Machine Repair and Maintenance,” F. Tian, P. Sun, and I. Duenyas provide theoretical guidance on designing the optimal contract to induce efforts from an agent to efficiently operate a machine. Although they consider the very general contract forms, the optimal contracts demonstrate simple and intuitive structures, making them easy to describe and implement in practice.