11 - Hidden Action

Question 1

What are the characteristics of principal agent models with hidden information?

Answer 1

• ex ante private information (i.e. quantity/quality)

- adverse selection

Question 2

What are the characteristics of principal agent models with hidden action?

Answer 2

• ex post private information (i.e. effort)
• agency model
• moral hazard

Question 3

What are the specific issues for hidden action?

Answer 3

 agent’s action/effort is unobservable
 verifiable signal imperfectly correlated with action
 optimal incentives with a noisy signal
 risk versus incentives
 inference problem

Question 4

What is the sequence of events (timing) in a principal agent model with hidden action?

Answer 4

t=0: Principal offers a contract.
t=1: Agent accepts or refuses contract.
t=2: Agent exerts effort.
t=3: Contract is executed.

Question 5

In hidden action, how can you find the optimal contract when effort is observable?

Answer 5

observable -> only participation constraint binding!

1) implement each of the effort levels into the agent’s utility and the firm’s profit function
2) compare which effort level brings highest profit

Question 6

How do wage-effort contracts differ depending on whether effort is observable or not?

Answer 6

when observable: wage can be based on effort

when not observable: wage has to be based on outcome (risk-sharing!)

Question 7

In hidden action, how can you find the optimal contract when effort is not observable?

Answer 7

for all (feasible) effort levels:

1) set up the PCs and ICs, based on expected utility
2) maximize expected profit, s.t. the appropriate constraints
3) compare the expected profits of the different effort levels

Question 8

In hidden action, how can you check whether an effort level is implementable?

Answer 8

Set up all the PCs and ICs for the effort level, simplify and then solve so much that you can check whether the final inequality is feasible!