1. Unforeseen Contingencies, Incentives and Economic Power
Sripad Motiram
Associate Professor
IGIDR, Mumbai

2. Motivation Broad Ideas
Modern economics has not lived up to its promise - Walrasian turn
Post-Walrasian economics - better potential (Bowles & Gintis 1993, 2000; Stiglitz 1992; Akerlof 2006)
Unforeseen contingencies - one relatively underexplored component
Talk about Marshall. Explain what post-Walrasian economics means. Mention that indescribable is another term that is used. Also mention that endogenous preferences are another component that has been relatively underexplored. Talk about the influence of behavioral/experimental economics

3. Motivation Contested Exchange
Exercise of power can be made explicit
What do unforeseen contingencies add?
Literature - focus on abstract settings; developed countries
Conditions (Maskin 2001) applicable to developing countries
Terrorism, political instability, newer technologies (e.g. GM crops: Herring 2005)
Talk about the literature on incomplete contracts and bounded rationality

4. Analysis: Summary Principal-Agent model - moral hazard
Fixed investment by agent
Adverse unforeseen contingencies:
(i) Directly affecting agent
(ii) Affecting the returns on the project
Renegotiation - has to be endogenous
(i) Agent’s (Principal’s) welfare lower (higher), (ii) Ambiguous - interpretation based upon rents due to private information
Mention that the comparison is between situations when contingencies are foreseen and when they are not.

5. Analysis: Summary Renegotiation does not arise Contested Exchange
Timing crucial
Contested Exchange
Unforeseen contingencies: add another layer
Exercise of power by both parties

6. Literature Conceptualization Implications Contested Exchange
Kreps 1979, 1992; Dekel et al. 1998; Ghirardato 2001; Al-Najjar 2002; Sagi 2006
Implications
Tirole 1999; Maskin 2001
Contested Exchange
Bowles and Gintis 1993, 2000
Mention that Maskin shows an irrelevance result

7. The Model Principal-Agent framework
Principal: risk neutral; agent: risk averse
Project needs effort (non-monitorable), fixed investment (monitorable) by agent
Marginal utility of effort independent of fixed investment
Share contracts (holds for general linear contracts)
Unawareness; Analyst vs. economic actor (Dekel et al. 1998)
Mention that the fixed investment by the agent is measured in terms of effort. Explain what you mean by unawareness and by the analyst, agent distinction

8. Unforeseen Contingency 1
E - Affecting agent only (fixed cost)
e.g. fixed rent; terrorist attack (Mumbai)
Timing
(1)----(2)----(3)----(4)---(5)----(6)
1: contract; 2: fixed inv e; 3: E occurs; 4: further inv (e); 5: effort; 6: end
Compare when E is foreseen and not
Only participation constraint different
Weaker when E is unforeseen
Give examples. Explain timing

9. Unforeseen Contingency 1
Results: If e is large,
Contract can exist when E is unforeseen even if does not exist when E is foreseen
Agent’s (Principal’s) welfare is lower (higher) - informational rent lost
Characterize a lower bound on e
Renegotiation does not occur
Explain the intuition. Highlight the fact that you characterize the lower bound

10. Unforeseen Contingency 2
E - Affecting returns on the project
e.g. sharecropping contract
Timing
(1)----(2)----(3)----(4)---(5)
1: contract; 2: fixed inv e; 3: effort; 4: E occurs; 5: end
Compare when E is foreseen and not
Both constraints and objective different
Ambiguous Results
Explain the sharecropping example

11. Unforeseen Contingency 2
Utility of the agent:
uf: When both parties can foresee
up: Agent cannot, but principal can
ua: Agent can, but principal cannot
uu: Neither can
Loss in agent’s welfare u=(uu- uf)
u=(uu- ua)+(ua- up)+(up- uf)
<= >= <=0
No Renegotiation (timing is crucial)
Explain the expressions and the connection with the first kind of unforeseen contingency. Go back to the previous slide and explain why timing is important

12. Contested Exchange
“... where some aspect of the good or service supplied is both valuable to the buyer and costly to provide, the absence of third-party enforcement of claims gives rise to endogenous enforcement strategies … unlike the transactions of Walrasian economics, the benefit the parties derive from the transaction depends on their own capacities to enforce competing claims.” - Bowles and Gintis 1993

13. Contested Exchange What do unforeseen contingencies add?
Additional layer (Anderlini et al. 2006)
Endogenous renegotiation need not emerge
Particularly relevant for developing countries
large number of transactions occur outside the ambit of formal law
practice might occur as regulation is being put in place, or even precede it, e.g. India: GM crops, competition policy

14. Economic Power Bargaining power of agent is lower
Sufficient Condition: Party 1 can impose (or credibly threaten) sanctions on party 2, when party 2 cannot do same
Can labor hire (fire) capital? (Samuelson)
“It’s really unfair. If a boss can fire me, why can’t I fire him?” (Truffaut’s Finally Sunday)
Efficiency wage, credit rationing models

15. Economic Power Result holds if the model is extended
Infinitely repeated game
A party can threaten to leave from the next period if there is no renegotiation
Can derive conditions under which either of the parties can exercise power

16. Conclusions
Two kinds of adverse unforeseen contingencies in a principal agent setting
Agent’s costs: welfare of agent declines
Returns: ambiguous - interpretation based upon private information rents
Contested exchange
Additional layer, exercise of power
Overall: Some new insights; some key insights remain