Contractual Externalities in Times of Uncertain Productivity

We propose a theory of contractual externality when an industry experiences a large productivity shock. We examine a continuum of principal-agent pairs. Each agent exerts costly hidden effort. The productivity of effort is subject to a shock common to all agents in the industry. Principals set contracts based on noisy signals about both agent-specific- and the industry average outcomes. When the latter signal is very noisy due to the large uncertainty associated with the industry shock, contracts are effectively weighted towards the more precise relative performance information. This creates complementarities in agents’ effort choices. Externalities arise because principals do not internalize the impact of their incentive provision on the average effort choice. If the expected productivity is high, risk-averse principals over-incentivise agents, triggering a rat-race in effort exertion, resulting in over-investment in effort and excessive risk relative to the second-best. The opposite occurs when the expected productivity is low.