Agency Theory

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents. An agency, in broad terms, is any relationship between two parties in which one, the agent, represents

Incentives of agency theory – Adam Smith and Incentive Contracts in Agriculture

In his discussion of the determination of wages, Adam Smith (1776, bk. 1, chap. 7) recognized the contractual nature of the relationship between the masters and the workers. He asserted the conflicting interests of those two players and recognized that the bargaining power was not evenly distributed between them; the masters generally had all

Incentives of agency theory – Chester Barnard and Incentives in Management

As we saw above, Smith (1776) already discussed the problems associated with piece-rate contracts in the industry. Babbage (1835) went a step further by under- standing the need for precise measurement of performances to set up efficient piece-rate or profit-sharing contracts: It would, indeed, be of great mutual advantage to the industrious work- man,

Incentives of agency theory – Hume, Wicksell, Groves: The Free-Rider Problem

Hume (1740) may be credited with writing the first explicit statement of the free- rider problem: Two neighbours may agree to drain a meadow, which they possess in common; because it is easy for them to know each others mind; and each must perceive, that the immediate consequence of his failing in his part,

Incentives of agency theory – Borda, Bowen, Vickrey: Incentives in Voting

Since the beginning of the theory on voting, the issue of strategic voting was noticed. Borda (1781) recognized it when he proposed his famous Borda rule: My scheme is only intended for honest men. We have to wait for Bowen (1943) to see a first attempt at addressing the issue of strategic voting. For

Incentives of agency theory – Léon Walras and the Regulation of Natural Monopolies

Walras (1897) defined a natural monopoly as an industry where monopoly is the efficient market structure and suggested, following Smith (1776), to price the prod- uct of the firm by balancing its budget. This led to the Ramsey (1927) and Boiteux (1956) theory of optimal pricing under a budget constraint. After some price cap

Incentives of agency theory – Knight, Arrow, Pauly: Incentives in Insurance

The notion of moral hazard, i.e., the ability of insured agents to affect the proba- bilities of insured events, was well known in the insurance profession.15 However, the insurance writers tended to look upon this phenomenon as a moral or ethical problem affecting their business. Arrow (1963b) introduced this concept in the economic literature

Incentives of agency theory – Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives

The separation of efficiency and redistribution in the second theorem of welfare economics rests on the assumption that lump-sum transfers are feasible. As soon as the bases for taxation can be affected by agents’ behavior, dead-weight losses are created. Then raising money for redistributive purposes destroys efficiency. More redistribution requires more inefficiency. A trade-off

Incentives of agency theory – Dupuit, Edgeworth, Pigou: Price Discrimination

When a monopolist or a government wants to extract consumers’ surpluses in the pricing of a commodity, it faces in general the problem of the heterogeneity of consumers’ tastes. Even if it knows the distribution of tastes, it does not know the type of any given consumer. By offering different menus of price-quality or

Incentives of agency theory – Incentives in Planned Economies

We must distinguish between the Soviet practice and the theory of planning devel- oped in the Western countries. As explained by Berliner (1976), In the early years of the Soviet period there was some hope that socialist society could count on the spirit of public service as a sufficient motiva- tion for economic activity.

Incentives of agency theory – Leonid Hurwicz and Mechanism Design

When general equilibrium theorists attempted to extend the resource allocation mechanisms to nonconvex environments they realized that new issues of commu- nication and incentives arose: In a broader perspective, these findings suggest the possibility of a more systematic study of resource allocation mechanisms. In such a study, unlike in the more traditional approach, the

Introduction to The Rent Extraction-Efficiency Trade-Off

Incentive problems arise when a principal wants to delegate a task to an agent. Delegation can be motivated either by the possibility of benefitting from some increasing returns associated with the division of tasks, which is at the root of eco- nomic progress, or by the principal’s lack of time or lack of any

The Rent Extraction-Efficiency Trade-Off: The Basic Model

1. Technology, Preferences, and Information Consider a consumer or a firm (the principal) who wants to delegate to an agent the production of q units of a good. The value for the principal of these q units is S(q) where S’ > 0, S” < 0 and S(0) = 0. The marginal value of the good is

The Complete Information Optimal Contract

1. First-Best Production Levels  First suppose that there is no asymmetry of information between the principal and the agent. The efficient production levels are obtained by equating the principal’s marginal value and the agent’s marginal cost. Hence, first-best outputs are given by the following first-order conditions and The  complete  information  efficient  production  levels  q∗

Incentive Feasible Menu of Contracts

1. Incentive Compatibility and Participation Suppose now that the marginal cost θ is the agent’s private information and let us consider the case where the principal offers the menu of contracts {(t*, q*); (t¯*, q¯*)} hoping that an agent with type θ will select (t*, q*) and an agent with type 6 will select

Information Rents

To understand the structure of the optimal contract it is useful to introduce the concept of information rent. We saw in section 2.2 that, under complete information, the principal (who has all the bargaining power by assumption) is able to maintain all types of agents at  their  zero  status  quo  utility  level.  Their  respective

The Optimization Program of the Principal

According to our timing of the contractual game, the principal must offer a menu of contracts before knowing which type of agent he is facing. Therefore, he will compute  the  benefit  of  any  menu  of  contracts   in  expected  terms. The principal’s problem writes as Using the definition of the information rents , we can

The Rent Extraction-Efficiency Trade-Off

1. The Optimal Contract Under Asymmetric Information  The major technical difficulty of problem jP k, and more generally of incentive theory, is to determine which of the many constraints imposed by incentive com- patibility and participation are the relevant ones, i.e., the binding ones at the optimum of the principal’s problem. A first approach

The Theory of the Firm Under Asymmetric Information

When the delegation of task occurs within the firm, a major conclusion of the above analysis is that, because of asymmetric information, the firm does not max- imize the social value of trade, or more precisely its profit—a maintained assump- tion of most economic theory. This lack of allocative efficiency should not be considered

Asymmetric Information and Marginal Cost Pricing

Let us view the principal as acting for a set of consumers and the agent as a firm producing a consumption good. The first-best rules defined by (2.4) and (2.5) can be interpreted as price equal to marginal cost since consumers on the market will equate their marginal utility of consumption to price. Under