Dynamics under Full Commitment in Agency Theory

Contracts are often repeated over time. Examples of such long-term relationships abound and span all areas of contract theory. Let us describe a few. The insurance contract of an agent entails bonuses and maluses that link his current coverage and risk premium to his past history of accidents. Labor contracts often continue to reward

Dynamics under Full Commitment: Repeated Adverse Selection

Consider the twice repetition of the model in chapter 2, where we can make various assumptions on the information structure and, in particular, on how it evolves over time. The goal of this section is to compare the optimal long-term contract with its static counterpart. 1. Perfect Correlation of Types and Risk Neutrality Let

Dynamics under Full Commitment: Repeated Moral Hazard

Let us now move to repeated moral hazard relationship. The main goal of this section is to show how the past history of performances may help the princi- pal to relax incentive compatibility constraints, even when there is no correlation between shocks in different periods. 1. The Model We will come back to the

Dynamics under Full Commitment – Constraints on Transfers: The Role of Implicit Incentives

In section 4.7, we reported the Fama (1980) argument according to which the labor market acts as an incentive instrument and provides managers with incentives to exert optimal effort levels. Indeed, managers want to influence the perception that the market has on their productivity. According to this argument, this desire for good reputation should

Agency theory: Informed Principal

In the basic framework of chapter 2, we have assumed that the uninformed party has all the bargaining power and makes a contractual offer to the privately informed agent. In the case of common value, i.e., where the principal’s utility function depends on the state of nature (V  = S(q, θ) − t), let us

Agency theory: Limits to Enforcement

In this volume, we have assumed that the judicial system is perfect and benevo- lent, and consequently can enforce any contract without cost. Implicit behind this enforcement is the use of penalties that prevent both partners from breaching the contract. We now briefly discuss a model of imperfect contractual enforcement. Consider the model in

Agency theory: Dynamics and Limited Commitment

In an intertemporal framework, what is needed for the optimal dynamic contract to be credible is not only the ability of the contractual partners to commit to a contract, but the stronger assumption that those two contractual partners also have the ability to commit not to renegotiate their initial agreement. The assumption that economic

Agency theory: The Hold-Up Problem

Let us now consider a setting where the agent has to make some initial investment before dealing with the principal. The motivation for this contractual setting is that the agent and the principal can only meet each other after the agent’s investment has been made. Such situations are likely to occur in market environments

Agency theory: Limits to the Complexity of Contracts

In most of this book, we have deliberately chosen to emphasize simple models, where shocks are discretely distributed both in the case of adverse selection and moral hazard. However, the analysis in appendices 3.1 and 4.2 also suggests that optimal contracts may have very complex shapes in the richer case where those shocks are

Agency theory: Limits in the Action Space

Let us now come back to an adverse selection context. Our goal in this section is to understand how one can possibly endogenize the action space used to contract with the agent. 1. Extending the Action Space We start with a highly stylized model of procurement between a principal (the buyer) and an agent

Agency theory: Limits to Rational Behavior

Even though incentive theory has been developed under the standard assumption that all players are rational, it can take into account whatever bounded rationality assumption one may wish to choose.38 However, there is an infinity of possible theories of bounded rationality and, in each case, the modeller must derive spe- cific optimal contracts. Let

Agency theory: Endogenous Information Structures

One often heard criticism of incentive theory is that it takes information structures as given. A more complete view of organizational design should account for the endogeneity of these information structures. To investigate these new issues, we now assume that the agent does not know his type a priori but can decide or not

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