Economics 410 Managerial Economics Sunday September 26, 1999

I. Incentive Contracting Game Theory concepts –Asymmetric Information –Moral Hazard –Adverse Selection Economics of Uncertainty Pure Theory of Insurance Preliminaries

I. Incentive Contracting Crucial Role of Uncertainty

The Big Issues Effort Ability to Monitor Uncertainty Effort/Result

The Wage Equation W =  +  (e + x +  y) Observed elements z and y Bargain over , ,  Where z = e + x

z +  y is an estimate of e Book incorrectly says (x +  y) is an estimate of e

z +  y is an estimate of e Why? What is the expected value of (z +  y)? Answer:e (e + x +  y)

Monitoring Intensity Principle If  is high Then V is set lower “It will pay to monitor the performance carefully

Equal Compensation Principle Two Different Activities Employer Cannot Monitor Unless marginal rate of return equal Employee will do all of one and none of the other

Other topics Ratchet Effect – Chapter 7 Role of Risk Neutral Agent – Chapter 7

Shapiro-Stiglitz Model of “Cheating” G – gains from cheating g> p (w – w*)N W* is alternative wage P – prob of getting caught N – the long run One possibility is to set w so that g = 0 “efficiency wage”

Spinoffs of S-S analysis Theory of Honor Theory of Reputations

Rents & Quasi-Rents Rent seeking activities Influence costs Job specific investments

Ownership “Residual rights of control” The Coase Theorem Example – a university

Chapter 12 – Compensation and Motivation “What to motivate?” Performance Evaluation Group Incentives

The End