Incentives Flashcards
Firm: Nexus of Contracts
Many Internal & Eternal Stakeholders
Diverging Goals
In these relationships there might be conflict:
• The firm wants the worker to work, but the worker wants to be
lazy.
• Shareholders want short-term returns, but the firm wants longterm returns.
• The firm wants suppliers to supply high-quality inputs, but the
suppliers want to save money and provide low-quality inputs.
Tension
In these relationships there might be conflict:
• It is in everyone’s interests to come together and form organizations that support specialization and trade.
• But, once they have established these organizations, there are incentives to misbehave.
• So, parties must safeguard themselves against the bad behavior of others before they enter into relationships with them.
Contracts
A contract is a voluntary agreement to organize a transaction.
• An explicit contract specifies verbally or in writing what each
party’s obligations are.
• An implicit contract is a set of expectations that each party has
about others’ behavior.
• In these slides we focus on explicit contracts!
Contracts: Enforcement
An implicit assumption in the study of contracts is that they are enforced.
• In reality, this is not so clear:
1. Some countries’ legal systems are inefficient/corrupt.
2. Going to court is very costly.
• If contracts are not easily enforceable, then they will not provide effective safeguards.
Contracts and Information
We will characterize contracting situations
according to information problems.
• If everybody can observe everything about everybody else at all times, then achieving efficient outcomes is easy.
• In reality, people contract without full information about each other, or about the economic environment
Asymmetric Information
• The core of this topic deals with environments in which one party knows something that the other does not.
• In particular we focus on two situations:
1. Before writing the contract, one party does not know something about the other’s characteristics.
2. After writing the contract, one party does not know what action the other took.
Timeline: Contracts
- Parties acquire characteristics.
- Parties design contract.
- Parties take actions.
- Results of the actions are realized.
- Payments are made
Ex-ante asymmetry information examples
- Education
- Health
- Car-Driving
Ex-post asymmetry information
- Building Investments
- Studying Hours in this course
- Effort in Sales
Compensation Scheme
- In the previous examples, notice that everything depends on the compensation system.
- If I give you 31/31 in your exam you will not put effort.
- If I do not compensate you for the quality of the construction of the buildings in the long run, you will not use good materials.
- If I pay you a fixed wage, you will not put effort on sales.
- An important lesson from these examples, is that even if there is moral hazard, we can as managers control it by arranging the right compensation scheme!
Pre-Contractual problems: Adverse Selection
- In many situation there are bad types with whom people do not want to trade.
- Unfortunately, these types may be exactly the ones that are attracted to trade.
- This may prevent trade with good types.
- Classic example: health insurance market:
- To whom do companies want to sell insurance?
- Who wants to buy insurance?
Communication
• In all our examples of pre-contractual asymmetric information,
there is somebody that loses out on trade.
• This person would like to identify themselves to the seller, and the
seller would like to know who this person is too.
• There should be some role for communication:
1. In some cases, you may be able to prove your type (medical
records in insurance).
2. But certainly not always.
Signaling
• A signal is an action that somebody can take to communicate their
type to others.
• This action might have nothing at all to do with the nature of the
transaction.
• A signal is effective when only some types want to send it, and
others not.
• Otherwise, if all types send the signal, nothing is learned, and we
are back where we started.
Conditions for an Effective Signal
• Different types must have:
1. a different benefit from sending the signal or
2. a different cost of sending the signal.
• If these conditions are met, good types are able to send the signal, and not be copied by bad types.
Screening
• So, signaling is when the person with the private information takes costly actions to signal the other part that they are the good types.
• Screening is when the person without private information design a contract to receive private information.
In general, in order to do screening, the uniformed party must make unattractive the transaction to those with whom he does not want to trade. The cost of doing this is to destroy some of the value of trading with good types. Examples:
1. 7am classes.
2. Low wages in some organizations such as charities.
Post Contractual Problems: Principal-Agent Model and Moral Hazard
• The principal engages the agent to perform on the principal`s behalf.
• But the agent might take opportunistic actions that harm the principal: moral hazard.
• Moral Hazard: Car Full insurance, NHS (overuse)
• Adverse Selection and Moral Hazard:
1. If you do well in the exam?
2. Health system?
Typical Principal-Agent Model
Performance Pay as solution:
• In the insurance example, we can force the driver to pay out some of
the cost of accidents.
• More generally, we want to pay the agent more when results indicate
he acted in the principals interests, and less when he didnt.
