1 Agency Game in the Long Run In the context here the long run means more than one transaction between two parties

2 Up until this time, we have seen that cooperation between two players typically requires enforceable contracts. In this set of notes we will see a modification to the conclusion. Some new language again. The 1st player in the agency game will be called the principal and the 2nd player will be called the agent. Remember the principal risks funds and because the agent may cooperate or appropriate. On the next slide I have reproduced the agency game without an enforceable contract.

3 agent cooperateappropriate Por performor breach rinvest.51 ior contract.5-1 ndon’t00 cinvest00 i p a l

4 Say the game will be repeated indefinitely period after period where the possible pay-outs each period are what they would be in the single period agency game. The agent has a dilemma now in that he can, or may want to, have a long term relationship with the principal. But, if the agent appropriates in a period the principal might get mad and not work any longer with the agent. Plus, the agent may be deterred from appropriating by the principal with a “tit-for-tat” strategy by the principal. This means the principal will reward cooperation and punish appropriation

5 Specific strategy of the principal The principal will have the basic strategy of investing in each period. If the agent cooperates in that period, then the principal will invest in the next period. But, if the agent appropriates in a period where the principal invests, then the principal will not invest in the following two periods. Then the principal will invest again and follow the rule set out here. Agent payout over three periods 1) if he cooperates.5,.5,.5 2) if he appropriates 1, 0, 0 So the agent is better off over the three periods by cooperating.

6 Review Back in the one period game context we saw the principal would not invest in this setting unless contracts were enforceable which transformed the invest appropriate outcome from (-1, 1) to (.5, -.5) Contracts lead to efficient outcomes. Now, in the long run context, we may not need contracts to bring about efficiency. If the agent wants an enduring relationship, and if the principal follows the tit-for-tat strategy mentioned, then retaliation by the principal brings about the efficient solution. Here it is said a long term relationship is developed and commitment results.

7 The end game problem In the real world relationships end. In other words, maybe a long run game with an infinite number of periods is not totally realistic. Finite, but long run, games with two players have a problem. If both players know when the last period is, then the game may not lead to cooperation. The last period can be thought of as a single period game. The agent has the incentive to appropriate and the principal does not have the ability to retaliate. So the principal will not invest in the last period. This makes the 2nd to the last period one in which the agent can appropriate because there will be no retaliation in later rounds. The principal sees this and does mot invest in the second to the last round. Actually, the logic is used in all rounds then, and the principal never invests without an enforceable contract. (Read box on page 230)

8 Open-ended relationships Here we have the agency game repeated indefinitely with many players. Each round of the game players form into pairs to partner in the game. At the end of each round 1) cooperation occurs but unforeseeable changes cause the parties to abandon relationships, 2) the relationship is dissolved by the principal if the agent appropriates 3) the relationship continues because cooperation happened (without unforeseeable changes.) If the relationship ends both must find new partners next period. All are not guaranteed a new partner next round.

9 Each agent has two choices; 1) cooperate each period and get.5 each period, 2) appropriate and get 1 some rounds and then search in future periods to get a new partner. This choice is like between getting a little payment each round, or getting a lot every once in a while and zero most of the time. It seems that in the real world there will be agents of both varieties. So, some cooperation is possible without enforceable contracts. Summary We have seen here that relationships may arise that allows for cooperation, even in the absence of enforceable contracts.

10 When legal disputes arise in long term relationships courts may try to repair the long term relationship instead of enforcing rights to parties. Repairing the relationship allows for continued performance of the efficient outcome.