The Value of Signals in Hidden Action Models: Concepts, Application, and Empirical Evidence

In: Contributions to Economics

Abstract

What happens if A wants to buy a good or service from B, but not all relevant characteristics can be fixed in a contract? This book gives a non-technical overview of various models dealing with this situation. Particular emphasis is put on the problem that the service includes various tasks and B is paid by a performance measure (signal). As a result, B might choose the wrong allocation of effort between tasks. Of course, the wrong allocation entails costs. A method to calculate these costs is suggested and it is explored how and when these costs occur. Some performance measures seem to be less prone to misallocation such as measures of firm performance. Consequently, one expects more use of firm performance measures when misallocation can be a problem. This hypothesis is examined empirically