New Institutional Economics Flashcards
Agency Theory
Principal and Agent have diverging utility functions and the Agent tends to act selfishly and opportunistically (with a potentially negative effect on the utility of P). Furthermore, there are information asymmetries (A is better informed than P). Thus, there is a need to align the agent’s interests (e.g. manager) with those of the principal (e.g. shareholder).
Hidden information:
is an ex-ante information asymmetry. The agent
possesses private information regarding personal characteristics which cannot be assessed by the principal → Consequence is
Adverse Selection:
e.g. an applicant is better informed about his
abilities than a potential employer and the principal anticipates that which has effects on the average salary and thus on the application rate of good candidates → Solutions: Signalling, Screening
Hidden action:
is an ex-post information asymmetry. The principal cannot observe the agent’s actions and is unable to assess if outcomes are determined by the agent’s effort or by environmental conditions → Consequence is
Moral Hazard: e.g. an employee withholds
effort at work (shirking) → Solutions: Contracting, Monitoring
→ Understand: problems of principal-agent relationships and find ways to reduce them
→ Therefore: Compare mechanisms to align interests (e.g. incentives, monitoring)
→ Based on this: decide between executive control, remuneration, reporting
Bounded rationality
Actors are assumed to strive for rational decisions but they are often unable to achieve the optimal solution or decision because they dispose limited information processing capacities.
They are constrained in their attention - that is what they can focus on – and their cognitive abilities.
Actors use heuristics.
Heuristics can be conceptualized as simplifying decision rules often informed by our experience of the past.
Opportunism
transaction partners act strategically, that is they try to maximize their own benefit. They emphasize their own benefit even at the expense of the benefit of others and they use tricks and deceptions
Signaling
• High ability applicants send a trustworthy signal (cost-intensive and verifiable, e.g.
education certificate, “Meisterbrief”) because they achieve the certificate with less
effort (at lower costs)
• Separating equilibrium: High ability applicants send the signal & low ability applicants
do not send the signal
• Predicted Outcome: Employees with higher education status are likely to earn higher
wages
Screening
Done by the recruiting organization
The principal will try to obtain as much private information about the agent as possible through intensive assessement activities
The key idea is to identify the most suitable canditates but the expenses for search and information costs are high
• Less informed employers seek to obtain information on applicants’ abilities
(assessment centers) and applicants thereby need to unveil private information
• Predicted Outcome: Higher probability to recruit high ability applicants, but alsohigher search and information costs
Contracting
• Outcome-based contracts reduce the risk of moral hazard as it aligns the interests of agents and principals
• Determinants of outcome-based contracts:
o Height of the goal conflict: the higher the perceived tension between the goals of
the agent and the principal (+)
o Risk aversion of the principal: outcome-based contracting increases the likelihood
that the outcome desired by the principal is reached (+)
o Outcome measurability: outcome-based contracting makes only sense if the
outcome can be measured (+)
o Outcome uncertainty: the more other factors are likely to determine the
outcome the more unlikely the parties agree in outcome-based contracts (-)
o Risk aversion of the agent (-)
o Task-programmability: tasks can be subdivided in smaller tasks and conducted
easily in a subsequent fashion (-)
Monitoring
- Monitoring reduces risk of moral hazard
- Effectiveness of monitoring increases with formal independence of oversight body
by independent actors, the supervisory board is formally independent
Institutions
- Rules of social game that determine our interactions in social, political and economic life
- Structure human interactions that enable us to anticipate the actions and reactions of other individuals
- Key purpose: creating order and decreasing uncertainty in human interactions
• Two types:
o Formal: contracts
▪ Institutions possess so called enforcement characteristics (e.g. braking a rule of a contract → negative consequences)
o Informal: norms of behavior
▪ If you disobey certain social norms of interaction, then you might face not legal but social sanctions
• Exist to basically deal with market imperfections and to reduce the cost of exchange even in presence of these imperfections
• Imperfections are:
o lack of information or information asymmetry
o transaction costs
o possibility of achieving economies of scale
o externalities which can be positive and negative (meaning that one partner in a market can benefit of be harmed by the actions of a third)
Transaction costs (TAC)
Transaction costs (TAC):
• Definitions
o Coase: Costs of using the market mechanism
o Arrow: Costs of running the economic system
o Williamsons: Economic equivalent of friction in physical systems
• Types
o Internal TAC: costs that are associated with transactions occurring within one organization
▪ Costs of structuring: costs of construction, maintenance and modification of an organizational structure (administration, ICT)
▪ Costs of operating: information costs (monitoring of staff); costs of physical transfer of goods (transport)
o External TAC: costs that are involved in exchanging goods and services between organizations
▪ Search and Information: screening various suppliers; information process
▪ Bargaining: determine the service level, type of delivery, exact component or material, the quality of the material, negotiate the price
▪ Monitoring: need to make sure that quality standards and service levels are being met
Property Rights Theory
Aim: Understand: property rights for resources and distribute them efficiently to facilitate exchange
Logic: Therefore: Compare effect of property rights regimes on TACs and social welfare
Use: Based on this: decide between Intellectual property, rights, open source, pollution rights
People: Coase, Demsetz
Hold up Problem
You don’t invest in a plant or a warehouse because there is a problem, the danger of
opportunistic behavior on your behalf. If you invest much you get stuck and become
dependent on the company. This is the hold-up problem. A solution is intelligent contracting
with penalties for contract renegotiations.
