HT - 06. Contracting

Question 1

Milgrom and Roberts (1992)

Answer 1

Oil and gas tax shelters –> Incentive problem model
Players: agent - general partner (GP)
principal - limited partners (LP)

Timing:

1. Sign a contract GP and LP
2. GP drills a well, LP pays costs of drilling
3. GP privately observes value of oil extracted
4. GP decides whether or not to complete the well

Payoffs:
Complete Well: GP = sR-C, LP = (1-s)R-D
Does not complete: GP = 0, LP = - D

D is sunk cost, socially optimal to complete if R > C but GP makes inefficient choice to complete iff sR > C

Mitigations?

• Monitor GP…costly
• Changing GP contract to induce social optimum
• Use exploratory wells –> much larger value wedge chance
• Reputational concerns –> Holmstrom model, not fully mitigating