Week 5: Principals and Agents: Theory

Question 1

Groupthink

Answer 1

the practice of thinking or making decisions as a group in a way that discourages creativity or individual responsibility.

phenomenon that occurs within a group of people, in which the desire for harmony or conformity in the group results in an irrational or dysfunctional decision-making outcome

Question 2

Condorcet Jury Theorem

Answer 2

theorem about the relative probability of a given group of individuals arriving at a correct decision

Question 3

Garbage Can Model

Answer 3

attempts to explain some organizational decision-making anomalies-in particular, decision making by “organized anarchies” where preferences are not clear, technology is not clear, or participation is fluid.

Problems, solutions, and decision makers move from one choice to another depending on the mix of recognized problems, the choices available, the mix of solutions available for problems, and outside influences on the decision makers. In short, problems are uncoupled from choices giving an image of “rummaging around” inside a garbage can. Problems are addressed based on a solution choice, but choices are made based on shifting combinations of problems, solutions, and decision makers. In this sense, decision-making appears “pathological” instead of rational.

The Garbage Can theory allows problems to be addressed and choices to be made, but does not necessarily following a rational process. Poorly understood and addressed problems can drift into and out of the garbage can process, depending on the situation and factors

Question 4

moral hazard

Answer 4

hidden action (e.g. effort)

Question 5

adverse selection

Answer 5

hidden or asymmetric information (e.g competence)

Question 6

moral hazard vs. adverse selection

Answer 6

MH = hidden action (effort)
AS = asymmetric information (e.g. competence)

MORAL HAZARD:
Conversely, moral hazard occurs when a party provides misleading information and changes his behavior when he does not have to face consequences of the risk he takes.
Example: assume a homeowner does not have home insurance, so homeowner is very careful and subscribes to a home security system that helps prevent burglaries.
Then, gets insurance. After insured, his behavior changes and he is less attentive, leaves his doors unlocked, unsubscribes to the home security system.

Adverse selection describes an undesired result due to the situation where one party of a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. The asymmetry causes a lack of efficiency in the price and quantity of goods and services.

Example: insurance company cannot differentiate between the individual who smokes and doesn’t exercise and the other person

Question 7

motivated actors

Answer 7

care about outcome even without payment

Question 8

relational contracts

Answer 8

outputs are observable but not verifiable. expectations of future cooperation sustain effort and payment. Example: IBM’s no layoff policy

Question 9

first-best

Answer 9

best imaginable outcome. unattainable, can’t maximize sum of utilities of players. Because Agent has a reason to “cheat”

Question 10

second-best

Answer 10

best achievable outcome

Question 11

incentive power,

Answer 11

k = base compensation
m = piece rate (incentive pay)
usually, there’s a tradeoff between m and k.

Question 12

what makes incentives high or low powered

Answer 12

high power: if 
low noise
few tasks and principals
repeated interaction
non-collusive competition
risk-averse principal

Question 13

reputation

Answer 13

Reputation - it is not necessary that the particular relationship be repeated; it may suffice if the principal is in business for a long time or in many activities, and reputation for misbehavior on one occasion can affect his ability to attract agents to work for him later or elsewhere.

Question 14

relational incentive contracts

Answer 14

“relational” incentive contracts-that is, agreements enforced by the parties’ concerns for their reputations, as opposed to formal contracts enforced by a court.

Question 15

Ex-ante budgetary controls vs. separate tasks vs. consolidated tasks

Answer 15

Ex-ante budgetary controls: When agencies have higher policy ambitions than principal, principal can obtain optimal policy at a minimum cost with no contractual payment.

Separate tasks: When an agency has a strong predilection for one task over another and can be expected to divert resources away from the latter towards the former.

Consolidate tasks: If the agency has strong need/interests in both tasks. Consolidation allows principals to link inducements across tasks, thus giving an agency greater incentive to choose higher policies for all tasks. When a principal prefers higher policy levels than the agencies on all tasks, tasks will be consolidated.