Hidden Commitment Power Is Powerless

Abstract

A principal who offers a contract may renege when her default option is sufficiently attractive. The size of this temptation, which inversely measures her commitment power, is often the principal's private information. This paper asks how contracting outcomes change under this information asymmetry. Disciplining off-path beliefs with the Intuitive Criterion, I find that every type of principal behaves and earns payoffs as if she were commonly known to have the least commitment power. Hidden commitment power is therefore powerless, although commitment power can be valuable under symmetric information. The result delivers an unambiguous policy lesson on how to mitigate this information asymmetry prior to contracting: only measures that improve the worst case have value. In an application to credit rating, when the cost of a rating system grows with its number of grades, a rating system that sorts issuers into ordered bands is optimal, and each issuer contracts on the terms warranted by the floor of her band.

arXiv commentJEL codes: C72, D82, D86 Keywords: commitment, signaling, intuitive criterion, credit rating