Journal of Institutional and Theoretical Economics, forthcoming
We discuss how trust is optimally maintained when promise-makers are privately informed about the costs of keeping their promises and efficient transfers are not feasible. To this end, we present a simplified version of the model in Li and Matouschek (2013) in which a principal and an agent are in a infinitely repeated relationship. The agent’s effort and output are observable but not contractible and the principal is privately informed about the per-dollar cost of paying the
agent, which is either one or infinite. We characterize the optimal relational contract, illustrate the methods used in solving games with one-sided asymmetric information and inefficient transfers, and discuss further applications.
Journal of Political Economy, 2021, 129(11), 3073-3140
Expert advice often extends beyond a simple recommendation, including information about alternative options. To explore the role of this referential advice, we enrich the expert’s informational advantage in a canonical model of communication with hard information. We show that when constructed just right, referential advice dissuades the decisionmaker from choosing options other than the recommendation, thereby making the recommendation itself more
persuasive. We identify an equilibrium in which, with probability one, the expert is strictly better off providing referential advice than she is in any equilibrium in which she provides a recommendation alone.
Management Science, 2022, 68(1), 37-51.
We develop a model to capture the novelty of innovation and explore what it means for the nature of market competition and quality of innovations. An innovator decides not only whether to innovate but how boldly to innovate, where the more novel is the innovation--the more different it is from what has come before--the more uncertain is the outcome. We show in this environment that a variant of the Arrow replacement effect holds in that new entrants pursue
more innovative technologies than do incumbents. Despite this, we show that the new entrant is less likely to disrupt an incumbent than the incumbent is to disrupt itself, and less likely to fail in the market. We extend the model to allow the incumbent to acquire the entrant post-innovation and show that this reverses the Arrow effect. The prospect of acquisition makes innovation more profitable but simultaneously suppresses the novelty of innovation as the entrant seeks to maximize her value to the incumbent. This reversal suggests a positive role for a strict antitrust policy that spurs entrepreneurial firms to innovate boldly.
American Economic Review (Papers & Proceedings), 2021, 111, 538-43
We combine a spatial model of innovation with Hotelling's model of competition. Innovations are vertically and also horizontally differentiated. Potential innovators choose not only whether to innovate but also how to innovate. The bolder they are with a new product, the riskier is the outcome but the softer will be the resulting market competition with existing products. We use the model to explore the interaction of competition and innovation and address several
classic questions. The recurring finding is that increased market competition drives not only more innovation but more novel and riskier innovation that offers a higher chance of breakthrough outcomes.
American Economic Review (Papers & Proceedings), 2020, 110, 199-205
Organizational stories are commonplace and a crucial force shaping employee behavior. We show how an organization's choice of story can be formally incorporated into its design problem. In our simple model, the organization optimally becomes either "purpose driven," which involves pairing flat money incentives with a story that emphasizes the importance of generating output (e.g., saving lives, putting a person on the moon), or "incentive
driven," which involves pairing steep money incentives with a narrower story that emphasizes the importance of maintaining ethical standards (e.g., maintaining quality, helping peers). We illustrate the applicability of these results using a variety of examples.
American Economic Journal: Microeconomics, 2019, 11(1), 44-78
Innovation is often the key to sustained progress, yet innovation itself is difficult and highly risky. Success is not guaranteed as breakthroughs are mixed with setbacks and the path of learning is typically far from smooth. How decision makers learn by trial and error and the efficacy of the process are inextricably linked to the incentives of the decision makers themselves and, in particular, to their tolerance for risk. In this paper we develop a model of trial and
error learning with risk averse agents who learn by observing the choices of earlier agents and the outcomes that are realized. We identify sufficient conditions for the existence of optimal actions. We show that behavior within each period varies in risk and performance and that a performance trap develops, such that low performing agents opt to not experiment and thus fail to gain the knowledge necessary to improve performance. We also show that the impact of risk reverberates across periods, leading, on average, to divergence in long-run performance across agents.
American Economic Journal: Microeconomics, 2017, 9(1), 217-41
We examine an infinitely repeated game between a principal, who has the formal authority to decide on a project, and a biased agent, who is privately informed about what projects are available. The optimal relational contract speaks to how power is earned, lost, and retained. It shows that entrenched power structures are consistent with optimal administration of power. And it provides new perspectives on why similar firms organize differently, even when
those organizational differences lead to persistent differences in performance, and why established firms fail to exploit new opportunities, even when they are publicly observable.
American Economic Journal: Microeconomics, 2015, 7(2), 158-87
We examine the relationship between the organization of a multi-divisional firm and its ability to adapt production decisions to changes in the environment. We show that even if lower-level managers have superior information about local conditions, and incentive conflicts are negligible, a centralized organization can be better at adapting to local information than a decentralized one. As a result, and in contrast to what is commonly argued, an increase in product
market competition that makes adaptation more important can favor centralization rather than decentralization.
American Economic Review, 2013, 103(6), 2328-51
A manager and a worker are in an infinitely repeated relationship in which the manager privately observes her opportunity costs of paying the worker. We show that the optimal relational contract generates periodic conflicts during which effort and expected profits decline gradually but recover instantaneously. To manage a conflict, the manager uses a combination of informal promises and formal commitments that evolves with the duration of the
conflict. Finally, we show that liquidity constraints limit the manager’s ability to manage conflicts but may also induce the worker to respond to a conflict by providing more effort rather than less.
Handbook of Organizational Economics, 2013, Princeton University Press, 373-431
We survey the theoretical literature in organizational economics on decisions in organizations, focusing on models where parties’ interests are imperfectly aligned. We break our discussion into two parts. In the first half, we study models of communication and decision making under fixed decision processes. These models categorize various ways in which strategic considerations with respect to information transmission can impose costs on organizations. In the
second half, we explore the tools that organizations have to mitigate these costs and endogenize the decision making process.
Journal of the European Economic Association, 2013, 8(2-3), 365-76
We examine how cheap talk communication between managers within the same firm depends on the type of decisions that the firm makes. A firm consists of a headquarters and two operating divisions. Headquarters is unbiased but does not know the demand conditions in the divisions’ markets. Each division manager knows the demand conditions in his market but is also biased towards his division. The division managers communicate with headquarters
which then sets either the prices or quantities for each division. The quality of communication depends on whether headquarters sets prices or quantities. This is the case even though, once communication has taken place, expected profits are the same whether headquarters sets prices or quantities.
Niko Matouschek, Paolo Ramezzana, and Frederic Robert-Nicoud
European Economic Review, 2009, 53(1), 19-36
We endogenize separation in a search model of the labor market and allow for bargaining over the continuation of employment relationships following productivity shocks to take place under asymmetric information. In such a setting separation may occur even if continuation of the employment relationship is privately efficient for workers and firms. We show that reductions in the cost of separation, owing for example to a reduction in firing taxes, lead to an increase in
job instability and, when separation costs are initially high, may be welfare decreasing for workers and firms. We furthermore show that, in response to an exogenous reduction in firing taxes, workers and firms may switch from rigid to flexible employment contracts, which further amplifies the increase in job instability caused by policy reform.
Journal of the European Economic Association (Papers & Proceedings), 2008, 6(2-3), 457-67
This paper compares centralized and decentralized price setting by a firm that sells a single product in two markets, but is constrained to set one price (e.g. due to arbitrage). Each market is characterized by a different linear demand function, and demand conditions are privately observed by a local manager. This manager only cares about profits in his own market and, as a result, communicates his information strategically. Our main results link organizational design
to market demand. First, if pricing is decentralized, it is always delegated to the manager who faces the flattest inverse demand function, regardless of the size of market demand. Second, even when pricing can be allocated to an unbiased headquarters, decentralization is optimal when markets differ sufficiently in how flat the inverse demand functions are. Finally, decentralization is more likely when, in expectations, local managers disagree more about prices.
American Economic Review, 2008, 98(1), 145-79
This paper compares centralized and decentralized coordination when managers are privately informed and communicate strategically. We consider a multi-divisional organization in which decisions must be adapted to local conditions but also coordinated with each other. Information about local conditions is dispersed and held by self- interested division managers who communicate via cheap talk. The only available formal mechanism is the allocation
of decision rights. We show that a higher need for coordination improves horizontal communication but worsens vertical communication. As a result, decentralization can dominate centralization even when coordination is extremely important relative to adaptation.
The Review of Economic Studies, 2008, 75(1), 259-93
We analyze the design of decision rules by a principal who faces an informed but biased agent and who is unable to commit to contingent transfers. The contracting problem reduces to a delegation problem in which the principal commits to a set of decisions from which the agent chooses his preferred one. We characterize the optimal delegation set and perform comparative statics on the principal’s willingness to delegate and the agent’s discretion. We also provide
conditions for interval delegation to be optimal and show that they are satisfied when the agent’s preferences are sufficiently aligned. Finally, we apply our results to the regulation of a privately informed monopolist and to the design of legislatives rules.
The Journal of Law and Economics, 2008, 51, 59-110
We analyze the role of the marriage contract. We first formalize three prominent hypotheses on why people marry: marriage provides an exogenous payoff to married partners, it serves as a commitment device and it serves as a signaling device. In each theory we analyze how a reduction in the cost of divorce affects the propensity to divorce for couples at any given duration of marriage. We then bring these alternative views of the marriage contract to bear on
the data using individual marriage and divorce certificate data from the US. We exploit variation in the timing of the adoption of unilateral divorce law across states to proxy a one-off and permanent reduction in divorce costs. The results suggest the dominant reason why individuals enter marriage contracts is that they serve as a commitment device.
The RAND Journal of Economics, 2007, 38(4), 1070-89
We analyze a cheap talk game with partial commitment by the principal. We first treat the principal's commitment power as exogenous and then endogenize it in an infinitely repeated game. We characterize optimal decision making for any commitment power and show when it takes the form of threshold delegation - in which case the agent can make any decision below a threshold - and centralization - in which case the agent has no discretion. For small biases
threshold delegation is optimal for any smooth distribution. Outsourcing can only be optimal if the principal's commitment power is sufficiently small.
The Journal of Industrial Economics, 2007, 55(2), 197-222
We examine the relationship between market conditions and the adoption of exclusive contracts. In particular, we develop a matching model in which agents may decide to adopt exclusive contracts to reduce bilateral bargaining inefficiencies in the presence of private information. We show that it is optimal for agents to adopt exclusive contracts in thin markets but not in thick markets and that for intermediate levels of market thickness strategic complementarities
lead to multiple equilibria. We study the welfare properties of market equilibria and discuss under what circumstances courts should enforce exclusive contracts.
Regional Science and Urban Economics, 2005, 35(5), 570-83
We explore the role of human capital investments in the location decisions of firms. We show that whether human capital investments act as a force for or against concentration depends on who is undertaking them and whether they are industry- or firm-specific. We also discuss the empirical predictions of our theoretical analysis.
Economics of Transition, 2005, 13(4), 573-603
In this paper we develop a framework to assess the economic impact of foreign investment projects. If investment projects interact with other industries in the host economy, either by buying inputs locally or by selling their own product to local downstream firms, they can create sectoral linkages. The expansion of upstream and downstream industries can feed back to the project’s own industry leading to a further expansion of the local industry. We study the
circumstances under which investment projects lead to the creation of sectoral linkages and characterize the factors that determine the project’s welfare impact. We link analytical findings to case studies undertaken for the EBRD.
The Journal of Law, Economics, and Organization, 2004, 20(1), 125-47
Private information can lead to inefficient bargaining between managers. I develop a property rights theory of the firm to analyze the optimal ownership structure that minimizes this bargaining inefficiency. I first show that a change in the ownership structure that reduces the managers’ aggregate disagreement payoff increases the probability that they realize efficient trades but also increases the cost of disagreement and can lead them to trade ‘too often.’ I then show
that joint ownership is optimal if the managers’ expected gains from trade are large and that either integration or non- integration is optimal if the expected gains from trade are small.
Products are increasingly made by assembling separately produced modules. Motivated by the notion that a firm's production function drives its organization, we explore how modular production shapes a firm's communication structure. Decisions are partitioned into modules and require closer coordination within modules than across. Each agent knows the state his decision must be adapted to. The principal decides whom each agent tells about his state, given that each communication link comes at a cost. We show that optimal communication networks follow a simple threshold rule and exhibit the threshold property. Comparative statics corroborate the
We develop a model of spatial competition in which the quality of a product is learned only after it is introduced to the market. Firms enter sequentially, choosing whether to innovate beyond the frontier and outside the scope of the existing market, or to nestle
in a niche between existing products. The uncertainty about a new product's quality depends on this choice and increases in the degree of horizontal differentiation from existing products. Innovation in this market is irregular with frequent changes of direction and cycles between frontier and niche innovation. We show how the ruggedness of the technological landscape itself deters innovation, generating less product differentiation, narrower markets, less entry and more intense competition than in a world of certainty. We develop and explore numerically a targeted policy intervention that encourages innovation when it ends prematurely. The interventions are short in duration but can restart self-sustaining innovation, generating large returns in welfare.