Coordination, Incentives, and the Ratchet Effect

Abstract

A concept of coordination costs is incorporated into a nonlinear variant of the model studied by Freixas, Guesnerie, and Tirole (1985) on the dynamic regulation of a firm with adverse selection and no commitment (the ratchet effect). Greater coordination costs give rise to two opposing effects. First, the value to the center of obtaining information increases, since this information can be used to eliminate coordination costs. Second, due to the nature of incentive-compatibility constraints, the costs of inducing revelation also increase. It is shown that the second effect always dominates. Greater coordination requirements increase the relative social costs of inducing separation (revelation) as opposed to pooling over and above any additional value of information to the center. A possible application of this theory to the experience of the Soviet economy is discussed.