1. Contracting The incentives of the employer (principal) and employee (agent) are different. A contract is designed to implement an outcome both parties prefer to not trading. Complete Information – no problem Incomplete Information – a little tougher

2. Principle-Agent Problem Once the contract is in place the agent has the incentive to act in own best interest. Examples: general contractor the board and the CEO the university and a professor Once I hire a contractor, she wants to finish the job quickly and at as low a cost as possible.

3. Principal Agent Problem More Formally Revenue = R(worker’s effort). Worker is paid wage & incurs cost = C(effort). Firm earns Revenue(effort)-Wage Worker earns Wage-Cost(effort) For worker to be willing to work, worker’s earnings > worker’s opportunity cost, O. The contract must be individually rational (IR).

4. Principal Agent Problem Example Market Price = 18 Output = 6e 1/2 Worker’s payoff is Wage - e 2 and she has an outside offer worth 50 Wage must be __________ (IR) Firm’s earns ___________

5. Principal Agent Problem More Formally Perfect Information (effort is observable): The IR constraint is W-C(e) > O or W > O+C(e) So the lowest acceptable wage for a given effort level is W = O+C(e) Firm picks (W*, e*) to maximize R(e)-W or R(e)-[O+C(e)] or R(e)-C(e)-O Firm’s profit is R(e*)-C(e*)-O

6. Principal Agent Problem More Formally Imperfect Information (effort is unobservable): Have to write a contract that gives the worker an incentive to select optimal effort. Firm could sell the worker the right to the output for fee, F. Worker now internalizes effort choice and maximizes R(e)-C(e)-F. (F is a sunk cost now) optimal effort is again e*.

7. Principal Agent Problem More Formally Worker’s profit is R(e*)-C(e*)-F. I.R. requires that R(e*)-C(e*)-F > O So firm sets R(e*)-C(e*) - O = F. Firm earns R(e*)-C(e*) - O and Worker earns O. just like with perfect information

8. Principal Agent Problem Example Worker’s profit = 18 * 6e 1/2 - e 2 -F Firm’s Profit = F. IR implies __________ Worker’s profit = _____ Firm’s profit = _______

9. Principle Agent Problem With imperfect information try to tie compensation to outcomes that are dependent upon unobservables -stock options -tipping a waitress

10. What About Risk? Typically think of firm as risk neutral and worker as risk averse. How does this impact our the problem?

11. What About Risk? Typically think of firm as risk neutral and worker as risk averse. Two part payment scheme (risk sharing) flat part and an incentive part More emphasis on invective component the more critical unobservables are less risk averse of agent lower the monitoring cost

12. Moral Hazard One side has hidden information about choices. Given a contract’s existence one changes behavior. “It’s a rental car so I don’t care how fast I drive over the speed bumps.” The principle agent problem is an example of a Moral Hazard problem.

13. Adverse Selection Sometimes contracts attract the wrong type of individual. ex: You are interviewing job candidates Candidate 1: thinks the salary is too low. Candidate 2: thinks this job sounds great. Who has the higher opportunity cost?

14. Adverse Selection ex: market for used cars. ½ are in good condition and worth $5000 ½ are in poor condition and worth $1000 If a buyer can’t tell the car quality expected value = $3000. No one would sell a good condition car for $3000. So only poor condition cars will be sold. If the cars are bad the price will fall to $1000.

15. Adverse Selection Other Examples: Health Insurance (question from PS 1) Bank Loans Solutions: Signaling – party with information conveys it credibly Screening – party without information gets other party reveal information

16. Signaling Must convince other party that your claim is true Every used car seller says their car in good condition, http://www.nwarktimes.com/classifieds/ http://www.nwarktimes.com/classifieds/ but only one that is telling the truth will offer to split the cost of having a neutral mechanic examine it. ex: Offering a Warranty Burning Money –Advertising, Big Office getting an MBA

17. Screening Must set up contract so that only desirable type will seek it out. Incentive Compatible - each type wants to present itself honestly. deductibles on property insurance physical exam for life insurance taking a used car for a test drive

18. OK, so what is it? Average consumption at Rick’s Iron skillet increased once they switched to a buffet service. Volvo drivers more likely to run stop signs. Bikers with helmets ride closer to cars.