Lecture 5 Topic 5

Question 1

incomplete contracts = ?

Answer 1

traders cannot easily verify quality, or they can observe quality, but cannot be verified in a court of law or by a third party

Question 2

complete contracts = ?

Answer 2

a contract that covers and controls every aspect of the transaction and is enforceable

Question 3

exogenous enforcement = ?

Answer 3

contract enforcement by third parties

the enforcers aren’t part of the exchange

Question 4

what do all contracts include?

Answer 4

mutual gain and conflict of interest

Question 5

what is the key difference between complete & incomplete contracts?

Answer 5

whether or not the division of gains is enforced by an external body

Question 6

principal agent problem = ?

Answer 6

agency problem

arises when there’s conflict of interest and an incomplete contract

Question 7

conflict of interest = ?

Answer 7

the actions of the agent affects the payoff of the principal leading to conflict of interest

Question 8

incomplete contract = ?

Answer 8

the agents actions or attributes aren’t known to the principal & can’t be subject to an enforceable contract

Question 9

principal agent problem categories = ?

Answer 9

hidden actions & hidden attributes

Question 10

hidden actions = ?

Answer 10

actions of the agent unknown to the principal

Question 11

hidden attributes = ?

Answer 11

attributes/characteristics of the agent unknown to the principal

Question 12

example of hidden actions = ?

Answer 12

health insurance will encourage people to act with more risk as they have the insurance cushion

Question 13

example of hidden attributes = ?

Answer 13

not knowing whether a car is defective or not

Question 14

moral hazard problem = ?

Answer 14

buying insurance policy may make buyers more likely to take the risk they have been insured against

Question 15

how does the principal agent problem work with the benneton model?

Answer 15

• agent supplies product for price p
• item has quality q
• principal (buyer) wants to pay low p for high q
• agent (seller) wants to sell for high p for low q

Question 16

what are the steps with the benneton model?

Answer 16

• principal (buyer) makes first move and offers a price
• agent (seller) decides what quality to provide based on price
• if agent provides low quality with probability t, buyer detects this and seller would have to sell for lower fallback price p squared
• alternatively, the agent could deliver high quality and the principal will purchase
• alternatively, the agent could deliver low quality and be undetected with probability 1-t

Question 17

what must the principal do in the benneton model to incentivise the seller to produce high quality

Answer 17

the principal must offer a price high enough to where the agent’s expected income from offering high quality is higher than if he were to offer low quality

Question 18

p - u = ?

where u has line on top

Answer 18

expected income if high quality is provided

(price - high quality)

Question 19

(1-t)(p-u) = ?

where u has line underneath

Answer 19

expected income if low quality is produced and undetected

(probability of undetection)*(price - low quality)

Question 20

t(p squared - u) = ?

where u has line underneath

Answer 20

expected income if low quality is detected

(probability of detection)*(fallback price - low quality)

Question 21

how is the nash equilibrium found with the benneton model?

Answer 21

p-u > (1-t)(p-u) + t(p2-u)

expected income of high quality being produced is higher or equal to expected income if low quality is produced