Monitoring, Management, Compensation, and Regulation Chapter 15. Principle and agent Organization: Markets and strategies ② Wen cao
Slides Reference: Industrial Organization: Markets and Strategies © Wen Cao Monitoring, Management, Compensation, and Regulation Chapter 15. Principle and Agent
Chapter 15-Objectives Chapter 15. Learning objectives Understand Moral hazard and Adverse Selection Understand principle-agent issue e Wen Cao
© Wen Cao 2 Chapter 15- Objectives Chapter 15. Learning objectives • Understand Moral Hazard and Adverse Selection. • Understand principle-agent issue Chapter 15. Learning objectives • Understand Moral Hazard and Adverse Selection. • Understand principle-agent issue
Chapter 15-Information Asymmetry Moral hazard issue ° Examples o Parents do not know whether kids prepare homework Owners do not know whether management shirks Hidden action vs hidden characteristics Design payment scheme to provide incentive to exert effort . Owner proposed a payment scheme(contract)that depends on observed output NoT effort e Worker accept or reject contract and choose optimal effort leve The Owner pays the worker based on realized output e Wen Cao
© Wen Cao 3 Moral Hazard Issue • Examples • Parents do not know whether kids prepare homework • Owners do not know whether management shirks • Hidden action vs hidden characteristics • Design payment scheme to provide incentive to exert effort. • Owner proposed a payment scheme (contract) that depends on observed output NOT effort • Worker accept or reject contract and choose optimal effort level. • The Owner pays the worker based on realized output. Chapter 15 – Information Asymmetry
Chapter 15-Information Asymmetry Principle-Agent Problem e Model Agent can choose to work hard e=2, or not e=0 Agent's reservation utility=10 w-e if he devotes an effort level 0 if he works at another place (15.1) e Owners profit f(agents unobserved effort)-wage payment R()-{B=2 ife=0.≡R(e) (153) Participation constraint: -accept the contract 2≥10 (154) Incentive constraint: work hard> no effort -2≥u2-0. (155) Contract: W(=12, WL=10. No uncertainty! e Wen Cao
© Wen Cao 4 Principle-Agent Problem • Model • Agent can choose to work hard e=2, or not e=0. • Agent’s reservation utility=10. • Owners profit = f(agent’s unobserved effort) – wage payment • Participation constraint: - accept the contract • Incentive constraint: work hard > no effort • Contract: w(H)=12, w(L)=10. No uncertainty! Chapter 15 – Information Asymmetry
Chapter 15-Information Asymmetry Principle-Agent Problem with uncertainty Model e Agent can choose to work hard e=2, or not e=0 Outcome is uncertain R(2-H probability 0.8 and R(O) H probability 0.4 L probability 0.6. 6) Agents reservation utility=10 U-{5m-· he devotes an e level of effort(57 o Owners profit f(agents unobserved effort)-wage payment R(e)= H ife=2 t= R(e)- L ife=0 (153) e Participation constraint:-accept the contract 2≥10 e Incentive constraint work hard> no effort 08u+02u-2≥0.4u+0.6-0. (159) Contract:W(H)=13>12,w(l)=8<10
© Wen Cao 5 Principle-Agent Problem with uncertainty • Model • Agent can choose to work hard e=2, or not e=0. • **Outcome is uncertain • **Agent’s reservation utility=10. • Owners profit = f(agent’s unobserved effort) – wage payment • Participation constraint: - accept the contract • Incentive constraint: work hard > no effort • Contract: w(H)=13>12, w(L)=8<10. Chapter 15 – Information Asymmetry