Lecture 4 - Agency Theory 1

Question 1

The principal-agent relationship is govern by a contract, chosen and designed by the ____. It is then the ___ who decides whether to accept the contract. Finally, it is the ___ who chooses the level of effort or an investment decision.

Plug in the missing words

Answer 1

PRINCIPAL, AGENT, AGENT

Question 2

The average weight pulled per worker decreases marginally as number of robe pullers increased.

Which of the following statements are NOT CORRECT?

A) the agency problem in this case is the free-rider problem
B) the decreasing average weight per worker added is due to the increased difficulty of monitoring individual efforts, giving room for free-riding
C) the situation may be explained by a prisoner’s dilemma game
D) this is likely a coordination problem rather than cooperation problem

Answer 2

WRONG: D) it is likely that the free-rider problem described in the case is a manifistation of cooperation problem rather than coordination problem

Question 3

Which of the following are ingredients to the principal-agent problem? Select multiple:
A) asymmetric information
B) conflict of interest
C) moral hazard
D) surplus available gains from trade
E) risk aversion

Answer 3

A) asymmetric information
B) conflict of interest
D) surplus available gains from trade

Question 4

Surplus available gains from trade is one of the three ingredients of the principal-agent problem. Which of the following statements are NOT CORRECT?

A) the basis for the P-A-relationship is that the principal is willing to pay more for the execution of a task than it will cost the agent
B) a P-A-relationship is established only when opportunities for value generating exchange exists
C) the P-A-relationship can be established even when it is value-destroying due to bounded rationality

Answer 4

WRONG:
C) the P-A-relationship can be established even when it is value-destroying due to bounded rationality

Question 5

Conflict of interest is one of the three ingredients of the principal-agent problem. Which of the following statements are NOT CORRECT?

A) one example of a conflict of interest is that the agent is inclined to shirk while the principal wants to agent to work as hard as possible
B) the problem arises as the agent has objectives that differs from value maximization for the principal
C) conflict of interest is the main facilitator of the need for incentives
D) conflict of interest implies an assumption of agent opportunism, which is taken into account in the contract design
E) none of the options are wrong

Answer 5

E) non of the options are wrong

Question 6

The agent is risk____, while the principal is risk____ - this affects the risk allocation in the relationship.
Plug in the right words:

A) neutral, averse
B) loving, neutral
C) averse, neutral
D) averse, loving

Answer 6

C)
The agent is risk AVERSE, while the principal is risk NEUTRAL - this affects the risk allocation in the relationship.
Plug in the right words:

Question 7

Asymmetric information is one of the three ingredients of the principal-agent problem. Which of the following statements are NOT CORRECT?

A) the agent has superior information compared to the principal with respect to the provision of effort
B) the principal is assumed to only be able to observe the output level
C) the principal cannot observe the circumstances under which the contract is executed
D) under the hidden action problem, the principal does not know all the characteristics of the agent

Answer 7

WRONG:
D) under the hidden action problem, the principal DOES KNOW all the characteristics of the agent, BUT NOT THE LEVEL OF EFFORT

Question 8

Regarding the hidden action problem, following statement is NOT TRUE:

A) it is also referred to as the moral hazard problem, because this is the equilibrium action of the agent
B) it is is one manifestation of the asymmetric information assumption
C) it happens when information asymmetry arises in the contract execution stage (ex-post)
D) it happens when information asymmetry arises in the contract acceptance stage (ex-ante)
E) it is relevant in the P-A-relationship, because the principal cannot measure precisely the effort of the agent due to external circumstance/uncertainty

Answer 8

WRONG:
D) it happens when information asymmetry arises in the contract acceptance stage (ex-ante)
–> this is the hidden characteristics (adverse selection) problem

Question 9

Regarding the hidden characteristics problem, following statement is NOT TRUE:
A) is also referred to as the adverse selection problem
B) this problem arises when the agent has more information than the principal during the contract design stage (ex-ante information asymmetry)
C) the principal is confronted with agents whose characteristics are unknown to the principal
D) the contract acceptance behaviour by the various agents is called adverse selection
E) agents with different characteristics will respond differently to the same contract
F) all options are correct

Answer 9

All options are correct

Question 10

In a hidden action problem, the principal is assumed to know all the characteristics of the agent (capabilities, aversion to effort, inclination towards risk), but in a hidden characteristics problem, this assumption is relaxed.

TRUE/FALSE

Answer 10

TRUE

Question 11

Two key constraints exist in order for a meaningful contract to be designed - which are these?

Answer 11

Participation constraint
Incentive compatibility constraint

Question 12

One of the two key constraint for meaningful contract design is participation constraint. Which of the following statements are NOT TRUE?

A) the prohibition of slavery means that people cannot be forced to accept contracts or engage in relationships
B) participation constraint refers to the requirement of voluntary participation
C) it implies that the principal must design the contract in a way that the agent earns at least his opportunity cost - otherwise the contract is not accepted
D) the intentions of the principal must match with the interests of the agent
E) the principal and agent start a relationship govern by a contract only when both parties do not lose

Answer 12

WRONG: D) the intentions of the principal must match with the interests of the agent
this is captured by the INCENTIVE COMPATIBILITY CONSTRAINT

Question 13

One of the two key constraint for meaningful contract design is incentive compatibility constraint. Which of the following statements are NOT TRUE?

A) in equilibrium, P chooses to incorporate incentives in the contract such that the self-interest of A is aligned with that of P
B) the intentions of the principal must match with the interests of the agent
C) the behaviour that P desires of A will be chosen by A only when the rules of the contract makes this effort attractive for A
D) in equilibrium, P can decrease incentives by increasing monitoring (limiting information asymmetry)

Answer 13

All options are correct

Question 14

Following are assumptions about the principal - select those that are NOT CORRECT

A) un-informed (lacks observability/ full information)
B) risk-neutral: indifferent about high-risk and low-risk choices
C) utility/ profit/ income depends on A’s efforts
D) has reservation utility
E) has all the bargaining power under the assumption of many As

Answer 14

WRONG:
D) has reservation utility
this is an assumption of the agent, who must be compensated at least for his opportunity cost of engaging in the relation

Question 15

Following are assumptions about the agent - select those that are NOT CORRECT
A) prefers high performance incentives (bonus tied to performance)
B) has all information
C) has disutility of effort: prefers to shirk all-else-equal
D) has reservation utility: must at least be compensated for the opportunity cost
E) can choose between different effort levels (ex-post effort)
F) efforts are imperfectly observed by the principal

Answer 15

WRONG:
A) prefers high performance incentives (bonus tied to performance)

The agent will all-else-equal prefer a fixed payment, since high performance incentives increases risk (the agent is risk-averse)

Question 16

Moral hazard results in an agency relation when there is:
A) externality
B) lack of participation constraint
C) control problem
D) inefficiency
E) two of the options are correct
F) three of the options are correct

Answer 16

F) three of the options are correct:

A) externality: A can engage in post-contractual behaviour that affects the utility of both P and A
C) control problem: P knows that A can deviate from optimum, but can only observe an imperfect signal of A’s effort
D) inefficiency: the action that A will take spontaneously is not optimal

Question 17

With respect to solving the moral hazard problem, one must make a trade-off between insuring the agent and giving him incentives.
Which of the following examples applies to “insuring the agent = removing risk”? (multiple options may be correct)
A) increasing monitoring efforts
B) increasing the strength of performance incentives (beta)
C) putting A on a flatter wage that is less performance dependent

Answer 17

A) increasing monitoring efforts
C) putting A on a flatter wage that is less performance dependent

B) increasing the strength of performance incentives (beta) –> this is a means of incentivizing, but increases risk for A

Question 18

With respect to solving the moral hazard problem, one must make a trade-off between insuring the agent and giving him incentives.
Which of the following statements are NOT CORRECT for this trade-off?

A) imposing stronger incentives implies that A works harder
B) imposing stronger incentives implies that A faces more risk (which A does not like)
C) imposing stronger incentives implies that A will demand a risk-premium
D) imposing stronger incentives makes P happier, but A less happy
E) imposing weaker incentives implies that A faces less risk
F) regardless of weaker or stronger incentives, there will be inefficiency

Answer 18

All options are correct

Question 19

In a complete contingent contract (no information asymmetry; no uncertainty; no risk preference), the best possible outcome will be realized (efficiency)

TRUE/FALSE

Answer 19

TRUE

Question 20

In a relationship between P and A, where there is information asymmetry and zero uncertainty, the best possible outcome will be realized (efficiency)

TRUE/FALSE

Answer 20

TRUE:
no uncertainty (no impact from outside circumstances) means that output (which is the only thing observable by P) is deterministically related to effort. Therefore, A is compensated directly for his effort and will want to supply maximum effort

Question 21

In the case that both P and A are risk neutral, but there are information asymmetry and uncertainty, the most optimal outcome (efficiency cannot be reached)

TRUE/FALSE

Answer 21

FALSE: e.g., P can offer A a franchise contract where A bears all risk (he is risk neutral) - now, A is incentivized to provide maximum effort because he works for himself

Question 22

For there to be an agency problem, there must be uncertainty, information asymmetry and risk aversity for the agent

TRUE/ FALSE

Answer 22

TRUE

Question 23

Foss and Laursen (2005) made a study of 1000 Danish firms.
One of the findings was:
“Firms that are exposed to much uncertainty will tend to adopt strong rewards (link performance and rewards tightly together)”

Is this consistent with agency theory predictions?

Answer 23

No:
Usually, assuming low/zero uncertainty, the performance outcome shall be closely tied to the effort level of A – but , with high uncertainty, rewards should theoretically not be tied closely to performance –> A is risk-averse, wherefore he would be very reluctant to take on the risk that is connected to both performance-dependent pay and high uncertainty

Question 24

Foss and Laursen (2005) made a study of 1000 Danish firms.
One of the findings was:
“Firms exposed to high uncertainty also adopt more multi-tasking”

Is this consistent with agency theory predictions?

Answer 24

No:
Higher uncertainty along with multi-tasking makes it more difficult for P to monitor and control agents. Normally, one would expect higher specialization of labour in the event of high uncertainty

Question 25

If a firm imposes a higher performance-based reward system, which of the following consequences are likely to arise?
A) more risk is imposed on A, increasing A’s demand for risk-premium (compensation for taking additional risk)
B) the firm’s total wage bill is expected to increase
C) employees (agents) will likely react to the change in the same way
D) productivity per wage amount should increase

Answer 25

All except of C:
employees, depending on age, nationality/culture, and individual characteristics, will react on the higher performance-based system differently due to different degree of risk-aversion.

High risk-aversion = high demand for risk-premium/ compensation for risk

Question 26

It is scientifically proven that people become more risk averse as they age

TRUE/ FALSE

Answer 26

TRUE

Question 27

It is scientifically proven that risk aversity depends much on the nationality of the individual, which may be due to local social security net or simply cultural differences

TRUE/FALSE

Answer 27

TRUE

Question 28

In the linear agency model, the agent’s wage is defined mathematically as a fixed component and a variable component depending on effort, uncertainty, and incentive strength

TRUE/ FALSE

Answer 28

TRUE

Question 29

In the linear agency model, how is the agent’s wage (W) defined mathematically?

Answer 29

W = W_0 + β(e + θ)

e: effort
θ : realization of a random stochastic variable (uncertain event)
β: performance incentive strength

Question 30

The agent’s demanded risk premium is dependent on:

A) degree of risk aversion
B) beta
C) wage uncertainty (variance of wage)
D) discount rate

Answer 30

A) degree of risk aversion, r
C) wage uncertainty (variance of wage), Var(W)

The risk premium of the agent is defined mathematically as:

RP = 1/2rVar(W)

Question 31

r: the degree of risk-aversion of the agent
If r>0: risk ___
If r=0: risk___
If r<0: risk___

Averse, loving, neutral

Plug in the three words in the right places

Answer 31

r: the degree of risk-aversion of the agent
If r>0: risk averse
If r=0: risk neutral
If r<0: risk loving

Question 32

The certainty equivalent of any “gamble” is the sure outcome (payoff) that result in the same expected utility as the “gamble”.

How is certainty-equivalent approximated?

Hint: agent’s risk premium is part of the equation

Answer 32

The CE can be approximated by:
CE=E(W)-1/2 r*Var(W)

The CE of each agent thus varies in accordance with the agent’s risk aversion and their correspondingly demanded risk premium

Question 33

The ___’s certainty equivalent is equal to the expected wage minus the risk premium for the agent, minus the cost of effort.

The ___’s certainty equivalent is the expected value of the effort of the agent, minus the expected wage for the agent, minus the risk premium.

principal; agent

Plug in the words in the right places

Answer 33

The AGENT’s certainty equivalent is equal to the expected wage minus the risk premium for the agent, minus the cost.

The PRINCIPAL’s certainty equivalent is the expected value of the effort of the agent, minus the expected wage for the agent, minus the risk premium.

Question 34

Which of the following are implications from the linear agency model? (Multiple options may be correct)

A) risk premium is a crucial component in agency theory
B) risk premium is a cost: if premium is reduced, value created is increase - more value is created if the agent is less risk-averse
C) the level of β chosen by P has to provide incentives for A to work hard
D) the level of β chosen by P has to provide insurance against uncertainty for A
D) optimal balancing of β results at best in the “second-best solution” due to information asymmetry –> n.b. the trade-off of incentive and insurance

Answer 34

All options are correct