Principle - Agent Model

Question 1

Who is the Informed and Uninformed Party in the model?

Answer 1

Principle = Uniformed Party
Agent = Informed Party

Question 2

Who proposes the contract and who accepts or rejects?

Answer 2

Principle Proposes Contract

Agent Accepts or Rejects

Question 3

What is the main assumption of the model?

Answer 3

Rationality- parties are Self-Interested

• Agents are willing to lie about their Info
• • Principle knows Agent behaves like this

Question 4

What is the Result of The Market for Lemons (Akerlof)?

Answer 4

Asymmetric Info —> Market Failure

Question 5

How does Market Failure in Market for Lemons occur w/ Asymmetric Info?

Answer 5

1. Buyers think 50% chance car is High Quality –> view all cars as Medium Quality
2. Demand Schedule Dm is Average of Dl and Dh - More L.Quality + Less H.Quality
3. Buyers know 3/4 are Low Quality- Demand falls to Dlm
   - All cars seen as Medium-Low Quality
4. Adjustment Process Continues- eventually all cars sold are L.Q
5. Price of H.Q so low- no longer willing to sell –> Removes Market for H.Q - MARKET FAILURE

Question 6

What is Ex-Ante Asymmetric Info?

Answer 6

Asymmetric Info exists before Parties involved Enter a Contract
-e.g. Insurance

Question 7

What is the Selection Problem?

Answer 7

Several Prob. Distributions from which Returns can be drawn - Only Entrepreneur (Agent) knows Prob. Dist. of their project

Question 8

What is Ex-Post Asymmetric Info?

Answer 8

Asymmetric Info exists After parties enter into a Contract

-e.g. Delegation- client + Lawyer

Question 9

what is Hidden Action Problem?

Answer 9

There are Several Prob. Dist. determining Returns

• BUT All entrepreneurs are alike- No Selection Problem
• Entrepreneurs choose which of Several Projects to Invest in - Banks can’t observe this choice

Question 10

What is the Standard debt Contract?

Answer 10

Bank loans K in Return for (1 + r)K if Successful

- Return = K if Unsuccessful

Question 11

What do we assume about Banks for Debt Contracts?

Answer 11

Competitive Banks - pay interest of d on deposits

• Receive Average Interest p (Rho) from Loans
• • Competition –> d = p (Rho)

Question 12

What is the Expected Profit and Participation Constraint under Debt Contracts?

Answer 12

Exp. Profit: E(πi) = pi [Ri^s - (1 + r)K]

Participation Constraint: E(πi) ≥ 0

Question 13

Under what condition does the Entrepreneur borrow under Debt Contract?

Answer 13

r ≤ (Ri^s - K) / K

Question 14

What acts as the Selection Mechanism under Debt Contract?

Answer 14

Returns - Ri

Question 15

What are Banks Exp. Profit?

Answer 15

E(πi) = pi (1 + r)K + (1 - pi)K

= (1 + rpi)

Question 16

What Occurs at Continuity Points for Banks due to their Exp. Profit?

Answer 16

pi (Rho) = rpi => dpi(Rho)/dr = pi > 0
BUT: Increased r –> Lower pi (Rho) at Discontinuity Points
=> Adverse Selection Effect

Question 17

How is pbar (Rho bar) calculated?

Answer 17

(Rho bar) pbar = r [(n1p1 + n2p2) / (n1+n2)]

Question 18

Due to Competition, what is the condition for Banks to Supply Loans?

Answer 18

(Rho) p ≥ d*

Question 19

What is Equilibrium in Loans Market when d* < pbar (Rho) and Banks can Observe R1s and R2s (Case 1A)?

Answer 19

Banks offer r~1 and r~2

- All Entrepreneurs Accept

Question 20

What is Equilibrium in Loans Market when d* < pbar (Rho) and Banks can NOT Observe R1s and R2s (Case 1B)?

Answer 20

Banks offer r~1 and r~2 - Type 2 mimics Type 1 for Lower r –> Losses for the Bank - p (Rho) = D < d*
- So Banks offer rbar
Type 1 Cross-subsidises Type 2 (Distribution)
All projects are funded & they all have Gross Rate of Return > Rate Bank need to Lend (d*) - Efficient Outcome

Question 21

What is Equilibrium in Loans Market when d* > pbar (Rho) and Banks can Observe R1s and R2s (Case 2A)?

Answer 21

Banks offer r~1 and r~2

- All Entrepreneurs Accept

Question 22

What is Equilibrium in Loans Market when d* > pbar (Rho) and Banks can NOT Observe R1s and R2s (Case 2B)?

Answer 22

Banks offer r~1 and r~2 - Type 2 mimics Type 1 for Lower r –> Losses for the Bank - p (Rho) = D < d*
- So Banks offer ONLY r~2 + Only Type 2 Accept
Distribution: Type 1 Loses + Type 2 does NOT gain anything beyond Full Info position
Efficiency: Type 1 NOT Funded despite Return allowing Bank to Break Even
- INEFFICIENT OUTCOME