Indjejikian and Nanda (J. Accounting and Economics 27 (1999) 177) establish that “lack of commitment” results in an expected economic loss, relative to a long-term full-commitment contract, if there is inter-period correlation of performance measures. They attribute this loss to a “ratchet effect”. We demonstrate the following. First, their proposed equilibrium is not sustained unless there is some form of limited commitment. Second, these limited commitment assumptions need not induce a “ratchet effect”. Third, the “ratchet effect” is neither necessary nor sufficient for an expected economic loss to occur—the loss is due to the principal's inability to commit ex ante to the second-period incentive rate.

Growing evidence indicates that neighborhoods affect human capital accumulation, raising concern that the exclusionary effects of housing discrimination could contribute to persistent inequality in the United States. Using data from HUD’s most recent Housing Discrimination Study and microlevel data on neighborhood attributes in 28 US cities, we find that minorities are steered toward neighborhoods with less economic opportunity and greater exposures to crime and pollution. Holding preferences and income constant, discriminatory steering alone can explain a disproportionate number of minority households found in high-poverty neighborhoods in the United States and the higher exposure of African American mothers to toxic pollutants.

In a standard financial economics model of asset pricing and value-maximizing firms, we show that better public information about firm-specific and economy-wide events affects the allocation of capital investments among firms and over time. The consequences for capital market outcomes, such as risk, risk premia, interest rates, firm prices, and the cost of capital, depend on investor preferences and whether improvements are to firm-specific or economy-wide information. We show that interest rates and risk premia tend to move in opposite directions and that the effects on interest rates often dominate the effects on risk premia in determining firm values and the cost of capital.

In an incomplete market with heterogeneous prior beliefs, we show that public information can have a substantial impact on the ex ante cost of capital, trading volume, and investor welfare. The Pareto efficient public information system is the system enjoying the maximum ex ante cost of capital and the maximum expected abnormal trading volume. Imperfect public information increases the gains-to-trade based on heterogeneously updated posterior beliefs. In an exchange economy, this leads to higher growth in the investors' certainty equivalents and, thus, a higher equilibrium interest rate, whereas the ex ante risk premium is unaffected by the informativeness of the public information system. Similar results are obtained in a production economy, but the impact on the ex ante cost of capital is dampened compared to the exchange economy due to welfare-improving reductions in real investments to smooth the investors' certainty equivalents over time.

Both soft, noncontractible, and hard, contractible, information are informative about managerial ability and future firm performance. If a manager's future compensation depends on expectations of ability or future performance, then the manager has implicit incentives to affect the information. We examine the real incentive effects of soft information in a dynamic agency with limited commitment. When long‐term contracts are renegotiated, the rewards for future performance inherent in long‐term contracts allow the principal partial control over the implicit incentives. This is because the soft information affects the basis for contract renegotiation. With short‐term contracts, the principal has no control over the basis for contract negotiation, and thus long‐term contracts generally dominate short‐term contracts. With long‐term contracts, the principal's control over implicit incentives is characterized in terms of effective contracting on an implicit aggregation of the soft information that arises from predicting (forming expectations of) future performance. We provide sufficient conditions for soft information to have no real incentive effects. In general, implicit incentives not controllable by the principal include fixed effects, such as career concerns driven by labor markets external to the agency. When controllable incentives span the fixed effects of career concerns, the latter have no real effects with regard to total managerial incentives—they would optimally be the same with or without career concerns. Our analysis suggests empirical tests for estimating career concerns that should explicitly incorporate noncontractible information.

We consider a dynamic trade-off model of a firm's capital structure with debt renegotiation. Debt holders only accept restructuring offers from equity holders backed by threats which are in the equity holders' own interest to execute. Our model shows that in a complete information model in which taxes and bankruptcy costs are the only frictions, violations of the absolute priority rule (APR) are typically optimal. The size of the bankruptcy costs and the equity holders' bargaining power affect the size of APR violations, but they have only a minor impact on the choice of capital structure.

We consider a setting in which a firm uses residual income to motivate a manager's investment decision. Textbooks often recommend adjusting the residual income capital charge for market risk, but not for firmspecific risk. We demonstrate two basic flaws in this recommendation. First, the capital charge should not be adjusted for market risk. Charging a market risk premium results in “double” counting because a risk-averse manager will personally consider this risk. Second, while investors can avoid firm-specific risk through diversification, a manager cannot. If the manager faces significant firm-specific risk at the time he makes his investment decision, then it is optimal to charge him less than the riskless return so as to partially offset his reluctance to undertake risky investments. On the other hand, the manager will vary his investment decisions with the pre-decision information he receives, which accentuates his compensation risk, and the firm must compensate him for bearing this additional risk. Hence, if the manager will receive relatively precise pre-decision information, then it is optimal to charge him more than the riskless return to reduce the variability of his investment decisions.

Recent articles have demonstrated that increased public disclosure can decrease firms’ cost of capital. The focus has been on the impact of information on the cost of capital subsequent to the release of the information (the ex post cost of capital). We show that the reduction in the ex post cost of capital is offset by an equal increase in the cost of capital for the period leading up to the release of the information (the preposterior cost of capital). Thus, within the class of models framing the recent discussion, there is no impact on the ex ante cost of capital covering the full time span of the firm. The extent to which information is made publicly or privately available affects the timing of the resolution of uncertainty and when the information is reflected in equilibrium prices, but there is no impact on initial equilibrium prices. Within a noisy rational expectations equilibrium, rational investors may actually benefit from a higher ex post cost of capital.

We derive sufficient conditions for ranking performance evaluation systems in multi-task agency models (using both optimal and linear contracts) in terms of a second-order stochastic dominance (SSD) condition on the likelihood ratios. The SSD condition can be replaced by a variance-covariance matrix of likelihood ratios (VCM) condition when the utility function is square-root, the performance measures are normally distributed, and for LEN models. We identify existing results derived under the LEN assumptions that rely on the VCM condition and, thus, also hold for optimal contracts.