Essays on the Impact of Information Asymmetry

Citation

Song, Myungkoo (2017) Essays on the Impact of Information Asymmetry. Dissertation (Ph.D.), California Institute of Technology. doi:10.7907/Z9571925. https://resolver.caltech.edu/CaltechTHESIS:06042017-015517588

Abstract

This dissertation consists of three essays focusing on how information asymmetry affects agents’ behavior across different environments. The first essay characterizes the optimal contract when a firm can employ two incentive schemes, promotion and pay for performance, simultaneously (Chapter 2). In the second essay, I study how information asymmetry can lead a firm to choose a less profitable short-term over a more profitable long-term project (Chapter 3). The other essay analyzes a career choice problem when agents have private information about their ability (Chapter 4).

Chapter 2 presents the effect of information asymmetry on executive pay structure to examine the cause of the rise in CEO compensation and wage inequality between CEO and other executives. To analyze the effect of the interaction of two incentive schemes, promotion and pay for performance, on CEO compensation and within-firm wage inequality, I embed a pay for performance framework into a tournament structure. The model shows that when CEO and managers contribute to a firm’s output independently, it is optimal for the firm to provide the CEO a compensation far beyond her reservation value in order to provide promotion incentives for managers. However, I find that the promotion incentive motive can disappear if there is interdependency between the CEO’s and managers’ outputs. In this case, the main purpose of a high CEO compensation is to induce the CEO to exert effort. The tension between incentives for CEO and managers makes it difficult to interpret the meaning of within-firm wage gap. As a possible solution, this paper suggests the use of CEO’s base salary to identify which incentive factor is driving the pay gap.

In Chapter 3, I study the optimal contract problem when a firm faces a long-term project. I consider a long-term project as one that requires an indefinite amount of time to complete its objective. I assume that the long-term project generates profits once it is accomplished. Using a continuous-time moral hazard model, I characterize the incentive compatibility condition in a relatively general contracting space. Moreover, I find a unique optimal contract under a restricted contracting space which consists of the two components: the termination level and the completion payment. The firm might invest in a short-term project: one that generates an instantaneous profit to the firm without any effect on the future, as analyzed by DeMarzo and Sannikov (2006). Comparison of optimal contracts for long and short-term projects provides an interesting insight to managerial short-termism: the firm, not the agent, could prefer a short-term project to a long-term project if there is a moral hazard problem.

Chapter 4 analyzes the role of asymmetry information on one’s career choice. I examine how people choose their career when they do not know ability of the rest of the applicant pool. The goal is to understand labor supply in the markets where ability is widely distributed. In particular, I consider a situation where there are two exclusive labor markets and the upper and lower bounds of one market’s payoffs are both higher than those of the other market. Under the market setting, agents decide which market to participate in. I find that the symmetric Bayesian Nash equilibrium of this problem is unique. In the equilibrium, agents are divided into two groups according to their ability. Members of the high ability group use a pure strategy and only apply to the more desirable market. Members of the low ability group apply to both markets with positive probability.

Thesis Files