Optimality of Debt under Flexible Information Acquisition (Review of Economic Studies, 87 (1), 2020, 487-536) (slides, online appendix)
Abstract: This paper studies a security design problem featuring flexible information acquisition. To raise liquidity, a seller issues a security backed by her asset in place at the price she proposes to a buyer. Before deciding whether to accept the offer, the buyer can acquire costly information about the underlying asset. This case differs from the existing literature on security design, in that the buyer has the full flexibility of choosing not only the amount of resources to spend in information acquisition, but also how to allocate them, depending on the shape of the security. Debt is shown to be the unique optimal security for the seller, as its payoff is the least sensitive to the value of its underlying asset. This minimizes the buyer's incentive to acquire information and mitigates the resulting adverse selection. I do not assume monotonicity of the feasible securities nor impose various distributional assumptions on information structures. Instead, I identify conditions for general information costs that support the results.
Financing Entrepreneurial Production: Security Design with Flexible Information Acquisition (with Yao Zeng) Review of Financial Studies, 32 (3), 2019, 819-863, Editor’s Choice (lead article) (slides)
Abstract: We propose a theory of security design in ﬁnancing entrepreneurial production, positing that the investor can acquire costly information on the entrepreneur’s project before making the ﬁnancing decision. When the entrepreneur has enough bargaining power in security design, the optimal security helps incentivize both eﬃcient information acquisition and eﬃcient ﬁnancing. Debt is optimal when information is not very valuable for production, whereas the combination of debt and equity is optimal when information is valuable. If, instead, the investor has sufficiently strong bargaining power in security design or can acquire information only after ﬁnancing, equity is optimal.
Properties of Optimal Accounting Rules in a Signaling Game (with Xu Jiang), Journal of Accounting and Economics 63, 2-3 (2017), 499-512.
Abstract: We characterize the properties of optimal accounting rule in a signaling game. An impatient rm sells shares to competitive investors. The rm can signal its private information about the fundamental by retaining a fraction of the shares. In addition, the rm can commit to disclosing information according to a set of accounting rules chosen ex ante. In- formation disclosure reduces signaling cost so that perfect disclosure is optimal. When perfect disclosure is impossible, the optimal accounting rule features a lower bound and a summary statistic of the fundamental. The interpretation of the lower bound is consistent with accounting conservatism and the statistic summarizes the information most relevant to the signaling game. The justification for accounting conservatism relies on the existence of information asymmetry and the in-feasibility of perfect accounting disclosure. This is consistent with the conjecture of LaFond and Watts (2008) that information asymmetry calls for accounting conservatism.
Coordination with Flexible Information Acquisition, Journal of Economic Theory 158 (2015), 721-738. (working paper version) (slides)
Abstract: We study flexible information acquisition in a coordination game. "Flexible" acquisition means that players choose not only how much but also what kind of information to acquire. Information acquisition has a cost proportional to reduction of entropy. Hence, players will collect the information most relevant to their welfare but can be rationally inattentive to other aspects of the fundamental. When information is cheap, this flexibility enables players to acquire information that makes efficient coordination possible, which also leads to multiple equilibria. This result contrasts with the global game literature, where information structure is less flexible and cheap information leads to a unique equilibrium with inefficient coordination.
Optimal Incentive Contract with Endogenous Monitoring Technology (with Anqi Li), Theoretical Economics 15(3), 2020, 1135-1173
Abstract: Recent technology advances have enabled firms to flexibly process and analyze sophisticated employee performance data at a reduced and yet signficant cost. We develop a theory of optimal incentive contracting where the monitoring technology that governs the above procedure is part of the designer's strategic planning. In otherwise standard principal-agent models with moral hazard, we allow the principal to partition agents' performance data into any finite categories and to pay for the amount of information that the output signal carries. Through analysis of the trade-off between giving incentives to agents and saving the monitoring cost, we obtain characterizations of optimal monitoring technologies such as information aggregation, strict MLRP, likelihood ratio-convex performance classfication, group evaluation in response to rising monitoring costs, and assessing multiple task performances according to agents' endogenous tendencies to shirk. We examine the implications of these results for workforce management and firms' internal organizations.
Coordination and Continuous Stochastic Choice (2nd R&R requested by the Review of Economic Studies) (slides) with Stephen Morris
Abstract: Players choose a stochastic choice rule, assigning a probability of "investing" as a function of a state. Players receive a return to investment that is increasing in the proportion of others who invest and the state. In addition, they incur a small cost associated with adapting the probability of investment to the state. If costs satisfy infeasible perfect discrimination (discontinuous stochastic choice rules are infinitely costly) and a weak translation insensitivity property, there is a unique equilibrium as costs become small, where play is Laplacian in the underlying complete information game (i.e., actions are a best response to a uniform conjecture over the proportion of others investing). The cost functional on stochastic choice rules may reflect the cost of endogenously acquiring information in order to implement a stochastic choice rule. With this interpretation, our results generalize global game selection results (Carlsson and van Damme (1993) and Morris and Shin (2003)); however, the mechanism works for general information structures and the source of uniqueness is different.
Abstract: We study liquidity provision by decentralized financial intermediaries (i.e., dealers)in a dynamic model of asset markets. When inventory cost is low (high), dealers provide more (less) liquidity by holding more (less) inventory, the market is liquid(illiquid), and interdealer trading is active (inactive). When inventory cost is medium,a dealer provides more liquidity if and only if other dealers do so, leading to strategic coordination motives and multiple equilibria. Switching between equilibria implies the potential for liquidity declines without fundamental shocks. A smaller trading friction among dealers effectively reduces inventory cost and hence reduces the possibility of multiple equilibria.
Organizations and Coordination in a Diverse Population (under review) with Liang Dai
Abstract: We study how organizations can exist to facilitate coordination by mitigating strategic uncertainty in a diverse population. Members of an organization are obliged to take collective actions, which mitigates strategic uncertainty but may also result in actions detrimental to some members, thus jeopardizing the sustainability of the organization. This tradeoff caps the size of organizations and limits the resulting welfare improvement. Organizations can exist only if coordination motives dominate the diversity of the population, up to a size limit. Our framework can be applied to shed light on the impact of immigration or polarization on the inclusiveness of the social order.
Abstract: We study the interaction between the usual inside information (about asset values) and information about its existence (i.e., about the existence of insiders) in an otherwise standard continuous-time Kyle-Back model. Interestingly, only the inside information, conditional on its existence, rather than the information about its existence, is revealed in equilibrium and affects asset prices and market liquidity, and it is revealed asymptotically in the long run. Our model sheds light on the impact of stock market regulations on market liquidity and reconciles the relevant mixed empirical findings.
Abstract: We study optimal accounting rules that alleviate inefficiencies caused by managerial private benefits. An entrepreneur raises capital from investors by designing a security and an associated covenant. The covenant allocates the control right of the project to the entrepreneur or investors in an intermediate period, according to a public signal. The party obtaining the control right can decide whether to liquidate or continue to generate a random cash flow. The entrepreneur enjoys private benefits from continuation, which may induce inefficient decisions. The regulator designs the accounting rule to alleviate potential inefficiencies. The optimal rule is characterized by a threshold, with a higher threshold representing more conservative accounting. The first-best is always achieved under small private benefits. For large private benefits, first-best is unachievable, and the threshold decreases in private benefits. Our result suggests that higher managerial private benefits call for less conservative disclosure rules. Our results also suggest that more conservative accounting rules are associated with, but not the cause of, more efficient investment decisions. This implication is consistent with the empirical facts (e.g., Lara et al. 2016), but the underlying mechanism differs from those offered in the literature. Finally, our results are robust to various forms of security design, and the contract used in equilibrium is renegotiation-proof.
Abstract: We study a dynamic contracting problem in which the principal can allocate his limited capacity between seeking evidence that confirms or that contradicts the agent's effort, as the basis for reward or punishment. Such flexibility calls for jointly designed monitoring and compensation schemes practically relevant but novel in the literature. When the agent's continuation value is low, the principal seeks only confirmatory evidence, but when the agent's continuation value exceeds a threshold, the principal switches to seeking mainly contradictory evidence. Moreover, the agent's effort can be perpetuated if and only if both synergy and flexibility in monitoring are sufficiently large.
Work in Progress
A Dynamic Theory of Payment Systems and Financial Fragility, with Stephen Morris and Yao Zeng