This paper argues that the effects of capital regulation on banks' risk-taking decisions depend critically on whether banks voluntarily hold equity capital. We introduce a model of banking regulation that incorporates default costs and motivates banks to hold some equity as a buffer against default. Heterogeneous banks choose their portfolio risk and theircapital holdings, with more able banks choosing riskier projects and holding less voluntary equity. If banks hold no voluntary equity, introducing capital requirements has the desired effect of making banks' project choices more prudent. If banks voluntarily hold equity, however, binding capital requirements will instead incentivize them to undertake riskier projects. In the latter case, social welfare is therefore likely to fall following the capital mandate.

I compare authority structures in a principal agent screening model where the agent's type determines his payoff and his preferred activity level. The uninformed principal incurs an externality and she is able to propose a revelation mechanism with contingent transfers. Under 'principal authority' (the agent needs the principal's agreement for his activity), the optimal mechanism is a standard screening contract and activities are downwards distorted. Under 'agent authority' (the agent can pursue the activity at his own discretion), reservation utilities become type dependent and the sign of the payoff externality shapes contractual outcomes. Specifically, (1) negative externalities (the principal prefers a smaller activity than her agent) now trigger upwards distortions; (2) a subset of agents is being 'left alone' under the mechanism; and (3) agent authority is always associated with larger activities than principal authority. Finally, I show that under simple symmetry assumptions, agent authority always generates a higher total surplus than principal authority.

We introduce a model of the banking sector that formally incorporate a buffer function of capital. Heterogeneous banks choose their portfolio risk, bank size, and capital holdings. Banks voluntarily hold equity when the buffer effect against the risk of default outweighs the cost advantages of debt financing. In the optimum, banks with lower monitoring costs are larger, choose riskier portfolios, and have less equity. Binding capital requirements or levies on bank borrowing are shown to make higher-risk portfolios more attractive. Accounting for banks’ interior capital choices can thus explain why higher capital ratios incentivize banks to undertake riskier projects.

I study a simple principal agent screening model where the agent's type determines hispayoff as well as his preferences over activity levels. The agent's activity inflicts a payoffexternality on the principal, and she proposes a revelation mechanism to the agent.When the agent needs the principal's consent to undertake the activity (Principalauthority), the optimal contract has standard properties and stipulates inefficientlylow (efficient) activities for the low-type (high-type) agent. When instead the agenthas 'authority' over the activity so that his participation constraint becomes typedependent, the principal (1) implements the efficient activity as long as the payoffexternality is not too large; and (2) if it is large, outcomes depend on the sign of theexternality. While agent authority often yields a larger total surplus (always so whenexternalities are positive), principal authority can be more efficient when the activitygenerates large negative externalities. Finally, uner the optimal mechanism all agents'work harder' under agent authority than under 'principal authority'.

In this paper, I study bilateral trade, where the seller can undertake specific investments before the binary trade transaction takes place. I identify a novel reason for hold-up and contractual inefficiency in this canonical setting. The investing party can shirk for strategic reasons; that is, exert an effort so low that trade becomes inefficient and is being rescinded. Under a fixed-price contract (the second-best mechanism in the absence of the shirking problem), strategic shirking can arise regardless of the initially contracted trade price. Moreover, if a fixed-price contract leads to strategic shirking, there exists no general revelation mechanism to restore equilibrium trade. I show that the shirking problem is more severe when the parties trade after having learned the buyer's valuation, as opposed to the case of an "experience good" where trade is finalized before this information materializes. Finally, when both buyer and seller undertake specific investments, shirking and non-shirking equilibria are shown to coexist.

The tax competition for mobile capital, in particular the reluctance of small countries to agree on measures of tax coordination, has ongoing political and economic fallouts within Europe. We analyse the effects of introducing a two tier structure of capital taxation, where the asymmetric member states of a union choose a common, federal tax rate in the first stage, and then non-cooperatively set local tax rates in the second stage. We show that this mechanism effectively reduces competition for mobile capital between the members of the union. Moreover, it distributes the gains across the heterogeneous states in a way that yields a strict Pareto improvement over a one tier system of purely local tax choices. Finally, we present simulation results, and show that a dual structure of capital taxation has advantages even when side payments are feasible.

The paper studies a federal system where (a) a region provides non-contractible inputs into the social benefits from a public policy project with spillovers to other regions, and (b) where political bargaining between different levels of government may ensure efficient decision making ex post. Allowing intergovernmental grants to be designed optimally, we ask whether project authority should rest with the region or with the central government. Centralization is shown to dominate when governments are benevolent. With regionally biased governments, both centralization and decentralization yield inefficiencies and the second-best institution depends on parameter values if political bargaining is prohibited. When bargaining is feasible, however, the first best can often be achieved under decentralization, but not under centralization. At the root of this dichotomy is the alignment of decision making over essential inputs and project size under decentralized governance, and their misalignment under centralization.

The paper considers a two-tier institution in which government provides public services, but individuals can opt out of public provision (but not taxes). Funding for the public service is chosen endogenously by majority vote, and we first provide necessary and sufficient conditions for a majority vote equilibrium. In line with existing results, the equilibrium tax rate usually falls below the one found in a one-tier system (opting out of public consumption is prohibited) as the public system loses the political support of the rich who exit. We prove that when the two-tier system majority dominates a purely private system, a majority in society always welcomes a transition from a one-tier public system to a two-tier system, it is the only system that is stable in an evolutionary sense. Otherwise, a majority consisting of the middle class may be in favor of staying in a one-tier system (prohibiting exit) because of a slippery slope argument.

This paper analyzes the provision of goods with consumption externalities (such as public policies) in hybrid settings: the ‘good’ is provided in a democratic process by majority vote, but each individual agent is free to contribute additional amounts before or after the political decision has been made. Prominent examples include policy making in federal states, charities, and dual provision of health care. We show that regardless of the timing of private and public actions, the results of the median voter theorem apply. A move from a purely public system to a dual system with private ex-ante contributions is shown to be unambiguously preferred by everybody in society. In contrast, establishing an ex-post contribution regime may be opposed by a minority of high-preference individuals. The paper also derives results for a scenario with endogenous timing of private contributions. Most importantly, this general regime is shown to be majority preferred not only to the systems with ex-post and the ex-ante contributions, but also to an institutional setting with private but no public provision. JEL Classification: D02, D78, H11, H40, P16.

This paper shows that privatizing a public firm can be welfare improving even if the government is a welfare maximizer. We consider a setup where the firm’s owner (a profit-maximizing entrepreneur or a benevolent government) employs a manager who can invent and implement an innovative production technology. Wage arrangements are optimal given the verifiable information, all parties behave rationally and the information structure is the same in both governance modes. Nevertheless, privatization turns out to be preferable in a wide variety of situations. Government ownership yields the first best if producing under the ‘old’ technology is not viable.

The paper studies a world where a region provides essential inputs for the successful implementation of a local public policy project with spill-overs, and where bargaining between different levels of government may ensure efficient decision making ex post. We ask whether the authority over the public policy measure should rest with the local government or be centralized, allowing financial relationships within the federation to be designed optimally. We show that centralization is always dominant when governments are benevolent, and that both governance structures are otherwise inefficient as long as political bargaining is disregarded. With bargaining, however, the first best can often be achieved under decentralization, but not under centralization. At the root of the result is the alignment of decision making over both essential inputs and final project size under decentralization.

This paper considers a version of the standard holdup model, in which a buyer and a seller can undertake relationship specific investments before conducting their transaction. In this setting, we identify a novel reason for contractual inefficiency. An investing party (here, the seller) may shirk for strategic reasons, in particular, exert an effort so low that subsequent trade becomes inefficient. We first show that under a fixed-price contract which would otherwise be optimal and induce trade, strategic shirking can arise irrespective of the precontracted trade price. We then establish that if strategic shirking arises under a fixed-price contract, no general mechanism exists which restores efficient trade. Finally, we show that the defection issue is more severe when the parties trade after the buyer’s valuation was realized, as compared to a scenario where the trade transaction is finalized in a state of uncertainty.

Human capital theory distinguishes between training in general-usage and firm-specific skills. Becker (1964) argues that employers will only invest in specific training, not general training, when labour markets are competitive. The article reconsiders Becker's theory. Using essentially his framework, we show that there exists an incentive complementarity between employer-sponsored general and specific training: the possibility to provide specific training leads the employer to invest in general human capital. Conversely, the latter reduces the hold-up problem that arises with firm-specific training. We also consider the desirability of institutionalised training programmes and the virtues of breach penalties, and discuss some empirical facts that could be explained by the theory.

The paper considers a two-community model with freely mobile individuals. Individuals differ not only in their incomes, but also in their tastes for a local public good. In each jurisdiction, the amount of public services is determined by majority vote of the inhabitants, and local spending is financed by a residence-based linear income tax. When making their residential and political choices, individuals thus face a trade-off between the provisionary and redistributive effects of policies. We analyze this trade-off and show that Tiebout-like sorting equilibria often exist. If the spread in tastes among individuals is very large, an almost perfect sorting according to preferences emerges; otherwise, a partial sorting prevails and stratification into rich and poor communities is more pronounced. Importantly, we demonstrate that all these sorting equilibria exist whether or not individuals are allowed to relocate after voting.

The article studies an adverse selection model in which a contractible, imperfect signal on the agent's type is revealed ex post. The agent is wealth constrained, which implies that the maximum penalty depends on the contracted transaction (e.g., the volume of trade). First, we show that the qualitative effects of the signal can be unambiguously tied to the nature of the problem (e.g., whether the agent is in a “buyer” or a “seller” position). Second, the distortions caused by informational asymmetries may become more severe although more information is now available. Finally, the signal can actually serve to increase the agent's informational rents.

I investigate a model in which two parties A and B invest sequentially in a joint project (an asset). Investments and the asset value are nonverifiable, and A is wealth-constrained so that an initial outlay must be financed by either an agent, B (insider financing), or an external investor, a bank C (outsider financing). I show that an option contract in combination with a loan arrangement facilitates first-best investments and any arbitrary distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, I identify conditions under which the first best can still be attained. Then, either B-financing or C-financing may be strictly preferable, and a combination of insider and outsider financing may be strictly optimal.

The paper investigates an alternating-offers bargaining game between a buyer and a seller who face several trading opportunities. These items (goods or services) differ in their non-verifiable quality characteristics which gives rise to a moral hazard problem on the seller's part. For the special case of two goods, we completely characterize the set of subgame-perfect equilibria. We find that the seller always extends an option to return the good, while the buyer may suffer from this warranty. Also, qualitatively different types of equilibrium outcomes occur depending on the parameters of the model: (a) the seller may obtain a larger share of the surplus although the parties ex ante have symmetric bargaining positions, (b) the subgame-perfect equilibrium may entail inefficient trade, and (c) multiple equilibria may exist including equilibria with delay in negotiations. Finally, we analyze a situation where bargaining proceeds after the good was returned which is shown to reestablish uniqueness and efficiency of equilibrium.

The paper investigates research collaborations where one partner performs R&D at an initial stage whereas the second partner subsequently invests in the success of a joint project. We allow for any degree of uncertainty of the project's success. It is shown that exclusive ownership of one partner necessarily triggers suboptimal initial research even if renegotiation is admitted. Conversely, joint ownership in form of an equity joint venture or a contingent ownership structure (an option-to-buy arrangement) may facilitate an efficient outcome. In equilibrium, the initially chosen governance structure is always renegotiated which conforms well with empirical evidence.