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This paper investigates the optimality of sharp incentives in contracts where output prices are set at the time of contracting but are random in nature. It shows that when prices are specified with error, schemes involving sharp incentives might result in substantial deviations from first-best output levels. The randomness of prices creates arbitrage opportunities that are exploited by agents producing phenomena such as cost-shifting. Both linear and piece-wise linear contracts are shown to be subject to the possibility of arbitrage. The paper then demonstrates that incentive schemes that are arbitrage-proof exhibit diffuse incentives.

Keywords: incentives ; contracts ; arbitrage

Subject(s): Risk and Uncertainty

Issue Date: 2007

Publication Type: Working or Discussion Paper

PURL Identifier:

Total Pages: 16

JEL Codes: D81; D86

Series Statement: Risk and Uncertainty Program


Record appears in: University of Queensland > School of Economics > Risk and Sustainable Management Group Working Papers

Autor: Menezes, Flavio ; Quiggin, John


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