Joanna Tyrowicz

Empirics of contract theory

Institutional Economics

2

“But I thought you were going to talk about econometrics?!”

Alice said, “Would you please tell me which way to go from here?” The cat said, “That depends on where you want to get to.”

Lewis Carroll Your choice of econometric models depends on

The question you want to ask The data you have to answer the question The way you use the data to answer the question

We will talk about these three things and how they relate to different models.

3

What Are The Kinds of Research Questions?

What are the differences between governance structures?

What are the differences (and interdependencies) within

governance structures?

What factors affect choice of governance structures?

What are the implications of governance choice?

For performance within the transaction

For performance of other mechanisms, markets, etc.

How/Why do governance structures evolve? proliferate?

How does the institutional environment (political, legal,

social, market forces) affect the answers to these questions?

4

A Framework for Analyzing (Contract) Structures

Three Fundamental Elements of Transactions Allocation of value

What is the nature of value? How is price determined? Allocation of uncertainty

Product uncertainty Market uncertainty Party/behavioral uncertainty

Allocation of decision rights Decision rights over (physical/financial) asset use Decision rights over human assets/behavior Decision rights over product design, creation, delivery

In what ways does any one affect the other three?

5

A Framework for Analyzing (Contract) Structures

Fundamentals of Economic Organization (Brickley, Smith & Zimmerman) Structure of Decision Rights

Who positioned to make the “best” decisions (based on information availability, measurement costs, incentive scheme)?

Incentive System How to reward “good” decision making (and punish bad)? What is the value of a “good” decision?

Performance measures How can you tell if decisions are good or bad? What is the relevance of decision making to value creation?

Again, these are interdependent

6

A Framework for Analyzing (Contract) Structures

Basic Contract Structure

•Operative terms of agreement

•Mechanics of the terms

•Representations & warranties

•Covenants

•Positive

•Negative

•Conditions

•Termination

•Miscellaneous other terms

Exchange of property rights and terms of value (allocation of property, value, uncertainty)

Information disclosure (adverse selection)

‘Unilateral’ promises of behavior (do’s & don’ts) related to moral hazard potentialSet criteria and define decision rights to continue or terminate the deal

7

Problem 1: Definitions

It is impossible to measure what you can’t define: What is vertical integration?

Asset ownership? If so, what is ownership? Hierarchical control? If so, what about ownership?

What is asset specificity? Specific relative to what? The transaction? The

trading parties? The local market? The industry? If the motivation for opportunism is the quasi-rent, is

there a quasi-rent? What is its source? Size? What do we mean by “optimal governance structure”?

If economic efficiency, how do we evaluate governance performance? Can we isolate the role of governance?

8

Problem 2: Where Do I Get the Data?

There are large (commercial) datasets with information on various types of contracts: ExecuComp (CompuStat)- executive compensation SDC Platinum (Thompson Financial) – various

financing, IPO, mergers and acquisitions, and joint venture agreements

Collect your own: Collect from firms or government agencies that

oversee businesses Surveys of decision makers

9

Pro’s and Con’s

Large data sets containing data in specific terms of

contracts

Good: Large samples make statistical analysis and

generalization more robust

Good: Relatively low transaction costs of getting data

Bad: Relatively high price of data

Bad: Limited information about the actual structure of

the contract, so you cannot control for other

differences in terms that may be important

10

Pro’s and Con’s Primary Data Collection

Good: can collect the specific contract/transaction data in which you are most interested in a way that fits your hypothesis and model

Good: can examine relationship of different terms (Anderson, 1999)

Good: can combine surveys, contract forms, etc.

Bad: Relatively high collection costs

Bad: As a result, samples are typically small, which raises statistical problems

Bad: Case studies and surveys are suspect

11

Pro’s and Con’s Case Studies – observations from a single firm/industry

Good: tremendously rich detail on terms and management of contracts

Bad: may be difficult to gain (honest) cooperation

Bad: possibly limited statistical application

Bad: limited generalizable information

Bad: profession views them with suspicion

Good: tremendously rich detail on terms and management of contracts that cannot be replicated in other ways

12

If data are so hard to get, where did existing studies come from?

Many „make or buy” studies have no primary data related to the actual transactions.

Use industry/firm census data and secondary data sources that describe integration and market behavior

Hypothesize relations at a firm level and test (e.g. study of vertical integration in petrochemicals on the website)

Many studies

use the large data sets and

look at specific contract terms and

discount (or ignore) the interaction of omitted contract terms

13

If data are so hard to get, where did existing studies come from?

Many contracts are filed with regulatory agencies, which may be available for research: Federal Trade Commission/State: franchise agreements State departments of health: first contact physician

contracts Maritime Commission: container shipping contracts Federal Energy Regulatory Commission/State: utility

contracts Securities & Exchange Commission: corporate contracts

Executive compensation, financial, M&A, major transactions

“Sunshine laws”/FOIA: government procurements & concessions

14

If data are so hard to get, where did existing studies come from?

It’s Not What You Know, But Who You Know Many of the best papers on contracts are a result of

personal connections to people in places with access to contracts (e.g., Mayer & Silverman, Mayer & Nickerson, Heuth & Ligon; Crocker & Reynolds)

Luck Many good papers on contract structure and

performance were cases of being in the right place at the right time (e.g., Crocker & Masten studies of natural gas, Knoeber studies on poultry contracts, Dubois on land use)

15

A Central Repository of Contracts

The Contracting and Organizations Research Institute (CORI) is undertaking to create a collection of contracts and data on organizational forms as a resource for researchers. Over 30,000 contracts from SEC filings Over 5,000 contracts from other sources

2500+ Telecommunication interconnection agreements

500+ first contact physician contracts 100+ teachers’ contracts University contracts

http://www.cori.missouri.edu

16

Problem 3: I have it; now what do I do with it?

Statistical models depend on the question: Probit (to be or not to be?)

Ordered Probit: we have multiple, ordinal outcomes Logit/Tobit (how much to be?)

Multinomial Logit: we have multiple, non-ordinal outcomes

Conditional Logit: our data represent a panel Poisson (how many to be?) OLS Latent variable models: covariance based structural

equation models Production possibility frontier estimates=> Masten and Saussier paper on the web

17

Additional problems and pitfalls: Equilibrium perspective

Studies of contract choice assume the observed choice is optimal Doesn’t permit “bad” choices Doesn’t capture dynamic/disequilibrium adjustment

Doesn’t test the actual performance of governance choice

Survivorship and self-selection biases are rampant This is the realm of endogeneity Censored data issues

Use of panel data (cross-sectional/times series) Fixed effects models to isolate firm-specific traits (+/-)

18

Additional problems and pitfalls: Event study/hazard models

Look for “natural experiments”

Innovation/Rate of Adoption models

Multiple stage regressions (2SLS, 3SLS) Instrumental variables, SURE models

Structural switching models Iterative models

19

So what do we do about it?

Empirical method is pointless if you don’t have an interesting question

Be clear in understanding and defining the economic significance of theoretical variables and empirical variables

Look for “Natural Experiments” (≈ changes or differences in institutions) to discriminate theories/control endogeneity

Econometric methods getting more complex.

Data are costly to collect, difficult to code, but worth it!

20

Experience from doing contract empirics

Large literature on the theory of contracts: developed P-A models under asymmetric information

Much less empirical tests and estimations: for example adverse selection phenomenon well known theoretically but still not large number of empirical applications

Focus on ideas for structural estimation methods

Principal-Agent models (asymmetric information: moral hazard, adverse selection)

21

Experience from doing contract empirics

Reduced form versus structural econometrics: Reduced form tests

Test theoretical predictions: a lot of empirical tests Tests of the presence of asymmetric information Adverse selection versus moral hazard: reverse

causality

Structural estimation methods: Theoretical model in terms of observables Identification questions

22

The Logic of Modeling

Problems: In time agents learn (asymmetric information) ->

difficult to capture Two approaches:

Take contracts as given Assume contracts are optimal

23

The Two Approaches Take observed contractual terms and make no assumptions

on optimality: Paarsch and Shearer (2000, 2004) - tree-planting labour

contracts data. Dubois and Vukina (2004) - animal production contracts

data. Abbring, Chiappori, Heckman, and Pinquet (2003) - car

insurance data.

24

The Two Approaches Assume contracts are optimal and test implications of theory

on observables: Allen and Lueck (1992) examine the determinants of

contract choice (unimportance of risk). Ackerberg and Botticini (2002) if one controls for

endogenous matching between P and A, the A’s risk aversion significantly influence the contract choice.

Dubois (2002): risk sharing, incentives and land maintenance.

Wolak (1994): asymmetric information reduces output (boosts prices)

25

Wolak 1994 The case of public utility (water supply) in California

Carefully studied conditions Theoretical model designed to match it Empirical testing of the model:

Not to check if the theory holds To see what’s the impact of comparable options

Principal selling a good in quantity q to an Agent whose tastes are indexed by θ

Cross sectional data, one principal and several agents Utility functions with (t is the price, α,β are known

parameters): The Principal does not know θ but has belief F Econometrician: observes only realized q, t (but a large

number of qi, ti ..) and not necessarily the contract t (q)

26

Dubois and Vukina 2004 Contracts to vertically coordinate the production and

marketing of agricultural commodities common practice in many agricultural sectors.

The majority of agricultural contracts use high powered incentives.

In many production contracts in agriculture, all agents contracting with the same principal operate under apparently identical contract provisions.

Study the contract design problem and present the method that allows identification and estimation of structural parameters of the moral hazard model.

27

Dubois and Vukina 2004 Identify the heterogeneity among agents (they have

different risk aversion attitudes and their preferences are observed by the principal).

Test predictions aimed at assessing the empirical reliability of the model.

Use panel data containing individual settlements of production contracts between

a company and independent farmers.

Explain an apparent anomaly frequently observed in many agricultural contracts principals use seemingly uniform contracts for the

purposes of governing the relationships with heterogeneous agents

28

Dubois 2001 A different approach to moral hazard – threat of overuse. Use data on a developing country (Philippines) Modelling:

Current production affects future fertility If contracts long-term, optimal scheme would be assured by

using high powered incentives BUT contracts short-term Contracts incomplete, ‘cause cannot be contingent on land

fertility Principals less risk-averse than Agents (again: carefully

designed framework). Trade-off between production incentives, fertility incentives

and sharing of production risk: High powered incentives allow to share production risk Impossibility to commit to long-term contracts does not

allow to incorporate fertility incentives into the contract. Main conclusion area: land reform!

29

Summary Econometric methods getting more complex = more fitted to

conditions

“The binding constraint is not technique, but data availability.”

Masten & Saussier, 2002

Directions for future fun : Endogenous delegation Endogenous matching Moral hazard and adverse selection Multiprincipal and mutiagent models Dynamics