Asymmetric Information

Part 1
Principal-agent model

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Asymmetric Information
• Transactions can involve a considerable
amount of uncertainty
– Can lead to inefficiency when one side
has better information
• Asymmetric information
– The side with better information
• Private information

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Value of Contracts
• Contractual provisions
– Can be added in order to circumvent
some of the inefficiencies associated with
asymmetric information
– Rarely do they eliminate them

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Principal-Agent Model
• Principal
– The party who proposes the contract
• Agent
– The party who decides whether or not to
accept the contract
– And then performs under the terms of the
contract
– Typically the party with asymmetric
information
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Leading Models
• Two models of asymmetric information
– Moral hazard model
• The agent’s actions affect the principal, but
the principal does not observe the actions
directly
• Hidden-action model
– Adverse selection model
• The agent has private information before
signing the contract (his type)
• Hidden-type model
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 18.1
Applications of the principal-agent

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 First, Second, and Third Best
• First-best contract
– Full-information environment
– The principal could propose a contract
that maximizes joint surplus
• Could capture all of the surplus for himself
• Leaving the agent just enough to make him
indifferent between agreeing to the contract
or not

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 First, Second, and Third Best
• Second-best contract
– The contract that maximizes the
principal’s surplus
– Subject to the constraint that he is less
well informed than the agent
• Adding further constraints
– Leads to the third best, fourth best, etc.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 18.1 (a)
The Contracting ‘‘Pie’’

(a) Complex contract increases parties’ joint surplus

The total welfare is the area of the circle (‘‘pie’’); the principal’s surplus is the area
of the shaded region. In panel (a), the complex contract increases total welfare
and the principal’s surplus along with it because she obtains a constant share.

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certain product or service or otherwise on a password-protected website for classroom use.
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 18.1 (b)
The Contracting ‘‘Pie’’

(a) Complex contract increases principal’s share of surplus

The total welfare is the area of the circle (‘‘pie’’); the principal’s surplus is the area
of the shaded region. In panel (b), the principal offers the complex contract—even
though this reduces total welfare—because the complex contract allows her to
appropriate a larger share.
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certain product or service or otherwise on a password-protected website for classroom use.
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 Hidden Actions
• The principal
– Would like the agent to take an action that
maximizes their joint surplus
• The agent’s actions
– May be unobservable to the principal
– The agent will prefer to shirk
• Contracts
– Can mitigate shirking by tying
compensation to observable outcomes
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Hidden Actions
• The principal
– More concerned with outcomes than
actions anyway
• May as well condition the contract on
outcomes

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Hidden Actions
• The problem
– The outcome may depend in part on
random factors
– Tying the agent’s compensation to
outcomes exposes the agent to risk
– If the agent is risk averse
• Payment of a risk premium before he will
accept the contract

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Owner-Manager Relationship
• A firm: one owner and one manager
– The owner (principal) offers a contract to
the manager
– The manager (agent) decides whether to
accept the contract and what action e  0
to take
• An increase in e increases the firm’s gross
profit but is personally costly to the manager

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Owner-Manager Relationship
• The firm’s gross profit: g = e + 
– Where  represents demand, cost, and other
economic factors outside of the agent’s
control
• Assume  ~ (0,2)
– c(e) is the manager’s personal disutility from
effort
• Assume c’(e) > 0 and c’’(e) > 0

• Firm’s net profit: n = g – s

• Where s is the manager’s salary
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Owner-Manager Relationship
• Risk-neutral owner
– Maximize the expected value of profit
E(n) = E(e +  – s) = e – E(s)
• Risk adverse manager
– Constant risk aversion parameter, A > 0
– Manager’s expected utility:
A
E U   E  s   Var  s   c e 
2

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 First-Best
• Optimal salary contract
– The owner can pay the manager
• A fixed salary s* if he exerts a first-best level
of effort e*
• And nothing otherwise
– For the manager to accept the contract
(participation constraint)
E(U) = s* - c(e*)  0

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 First-Best
• The owner
– Will pay the lowest salary possible [s* =
c(e*)]
– Net profit: E(n) = e* - E(s*) = e* - c(e*)
– At the optimum, the marginal cost of effort
equals the marginal benefit, c’(e*) = 1

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.