Principle - Agent Model Flashcards
Who is the Informed and Uninformed Party in the model?
Principle = Uniformed Party Agent = Informed Party
Who proposes the contract and who accepts or rejects?
Principle Proposes Contract
Agent Accepts or Rejects
What is the main assumption of the model?
Rationality- parties are Self-Interested
- Agents are willing to lie about their Info
- Principle knows Agent behaves like this
What is the Result of The Market for Lemons (Akerlof)?
Asymmetric Info —> Market Failure
How does Market Failure in Market for Lemons occur w/ Asymmetric Info?
- Buyers think 50% chance car is High Quality –> view all cars as Medium Quality
- Demand Schedule Dm is Average of Dl and Dh - More L.Quality + Less H.Quality
- Buyers know 3/4 are Low Quality- Demand falls to Dlm
- All cars seen as Medium-Low Quality - Adjustment Process Continues- eventually all cars sold are L.Q
- Price of H.Q so low- no longer willing to sell –> Removes Market for H.Q - MARKET FAILURE
What is Ex-Ante Asymmetric Info?
Asymmetric Info exists before Parties involved Enter a Contract
-e.g. Insurance
What is the Selection Problem?
Several Prob. Distributions from which Returns can be drawn - Only Entrepreneur (Agent) knows Prob. Dist. of their project
What is Ex-Post Asymmetric Info?
Asymmetric Info exists After parties enter into a Contract
-e.g. Delegation- client + Lawyer
what is Hidden Action Problem?
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
What is the Standard debt Contract?
Bank loans K in Return for (1 + r)K if Successful
- Return = K if Unsuccessful
What do we assume about Banks for Debt Contracts?
Competitive Banks - pay interest of d on deposits
- Receive Average Interest p (Rho) from Loans
- Competition –> d = p (Rho)
What is the Expected Profit and Participation Constraint under Debt Contracts?
Exp. Profit: E(πi) = pi [Ri^s - (1 + r)K]
Participation Constraint: E(πi) ≥ 0
Under what condition does the Entrepreneur borrow under Debt Contract?
r ≤ (Ri^s - K) / K
What acts as the Selection Mechanism under Debt Contract?
Returns - Ri
What are Banks Exp. Profit?
E(πi) = pi (1 + r)K + (1 - pi)K
= (1 + rpi)
What Occurs at Continuity Points for Banks due to their Exp. Profit?
pi (Rho) = rpi => dpi(Rho)/dr = pi > 0
BUT: Increased r –> Lower pi (Rho) at Discontinuity Points
=> Adverse Selection Effect
How is pbar (Rho bar) calculated?
(Rho bar) pbar = r [(n1p1 + n2p2) / (n1+n2)]
Due to Competition, what is the condition for Banks to Supply Loans?
(Rho) p ≥ d*
What is Equilibrium in Loans Market when d* < pbar (Rho) and Banks can Observe R1s and R2s (Case 1A)?
Banks offer r~1 and r~2
- All Entrepreneurs Accept
What is Equilibrium in Loans Market when d* < pbar (Rho) and Banks can NOT Observe R1s and R2s (Case 1B)?
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
What is Equilibrium in Loans Market when d* > pbar (Rho) and Banks can Observe R1s and R2s (Case 2A)?
Banks offer r~1 and r~2
- All Entrepreneurs Accept
What is Equilibrium in Loans Market when d* > pbar (Rho) and Banks can NOT Observe R1s and R2s (Case 2B)?
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
