Principal-Agent Model

Question 1

What is the set-up of the Principal-Agent Problem?

Answer 1

• Asymmetric Information
• Principal offers a contract
• Agent chooses to accept and performs under terms of contract

Question 2

What are the types of private information?

Answer 2

• 1. Action
     - e.g. effort
     - e.g. smoking
• 2. Innate Characteristics
     - Uncontrollable
     - e.g. history of health problems

Question 3

What is the worker’s Moral Hazard problem?

Answer 3

• Agent has hidden information about their actions

- Best hidden action for agent may not always be best action for principal

Question 4

What are the two stages of the principal-agent problem?

Answer 4

• 1. Principal offers contract
• 2. Accept/not & how much effort to put in
     - Worker only accepts contract if benefit from doing so is greater than next best alternative
     - Effort level chosen is such that is maximises their utility taking into account pay and cost of effort
     
     • Only taking into account their own interests

Question 5

What is the condition of optimal effort?

Answer 5

• Optimal effort E* = MCE = MVPE
  • MCE = extra money needed to exactly compensate the agent for 1 extra unit of effort
    
    • Assume MCE constant
  • MVPE = extra output generated from 1 unit of effort * value of extra output
    
    • i.e. MPe * P = MVPe
    • Downward sloping

Question 6

What is the solution for observable effort?

Answer 6

If the contract stipulates no pay until E* is exerted and so long as that pay covers cost of effort for the worker and is just as high as the next job, worker will put in E*

Question 7

What occurs when effort is unobservable?

Answer 7

• Instead of effort, output (quantity/quality) is measured to offer an incentive scheme: S

Question 8

What is the incentive scheme S?

Answer 8

• S = a + bq
  
  • a: fixed payment
  • b: bonus for every output
    
    • “Power” of incentive scheme
    • Measures how closely pay is tied to output

Question 9

What are the degrees of incentive scheme’s?

Answer 9

• S1 = a
• S2 = a + bq
• S3 = bq
  
  • “High Powered” Scheme
• The steeper the scheme curve, the higher power that is attached to it

Question 10

What are the outcomes of VMPE(S1,2 and 3)?

Answer 10

• MVPE(S1) leads to 0 effort because only fixed payment is involved
• MVPE(S3) leads to greater effort than MVPE(S2)

Question 11

Theoretically what is the solution to unobservable effort and what is the consequence?

Answer 11

• The higher the payment for good quality output means the higher the return for increasing effort and the greater amount of effort the agent will exert
• The way to encourage agent to exert E* is to pay them based on value of their output
  • E* = MCE = MVPE
    
    • MVPE = MPE * P
    • Need to pay the value of the good
    • But if worker keeps all proceeds, firm won’t want to hire them

Question 12

What is one solution for unobservable effort?

Answer 12

• Pay fee to work, then keep all proceeds
• Principal gets triangle below axis as profit
• Co-op’s etc.

Question 13

What is a key problem with high power incentive schemes and the consequences?

Answer 13

• One problem with high powered schemes is they involve risk/uncertainty
  
  • Want to be paid a risk premium
    
    • Firm has to give workers the entire value of the product they are producing, plus more to cover the risk that those products are not of high quality despite high effort exerted (no fault of their own)
    • Workers trade off between risk free (S1) schemes and risky (S3, steeper) schemes
    • Risk of high powered schemes rests solely on the agent

Question 14

What are other possible incentives to encourage E*?

Answer 14

• Threat of job loss

- Internal promotions