Advanced Microeconomics II

Chapter Two
Principal Agent Model
Major Text
Hal R. Varian. -- 3rd edition
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Contents

 Definition and Concepts

 Incentives Contracting

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The Principal-Agent Relationship

One important way in which asymmetric

information may affect the allocation of
resources is when one person hires another
person to make decisions
 patients hiring physicians

 investors hiring financial advisors

 car owners hiring mechanics

 stockholders hiring managers

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The Principal-Agent Relationship

In each of these cases, a person with less

information (the principal) is hiring a more
informed person (the agent) to make decisions
that will directly affect the principal’s own well-
being

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Principal-agent problem
Principal-agent problem arising when
agents (e.g., a firm's managers) pursue
their own goals rather than the goals of
principals (e.g., the firm's owners).

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The Principal-Agent Relationship

Assume that we can show a graph of the

owner’s (or manager’s) preferences in
terms of profits and various benefits (such
as fancy offices)
The owner’s budget constraint will have a
slope of -1
 each $1 of benefits reduces profit by $1

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The Principal-Agent Relationship

Profits
If the manager is also the
owner of the firm, he will
maximize his utility at profits
of * and benefits of b*
*

U1

Owner’s constraint

Benefits
b*

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The Principal-Agent Relationship

Profits
The owner-manager maximizes
profit because any other owner-
manager will also want b* in
benefits
* b* represents a true cost
of doing business
U1

Owner’s constraint

Benefits
b*

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The Principal-Agent Relationship

Suppose that the manager is not the sole

owner of the firm
 suppose there are two other owners who play
no role in operating the firm
$1 in benefits only costs the manager
$0.33 in profits
 the other $0.67 is effectively paid by the
other owners in terms of reduced profits

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The Principal-Agent Relationship

The new budget constraint continues to

include the point b*, *
 the manager could still make the same
decision that a sole owner could)
For benefits greater than b*, the slope
of the budget constraint is only -1/3

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The Principal-Agent Relationship

Profits
Given the manager’s budget
constraint, he will maximize
utility at benefits of b**
Agent’s constraint

*
Profits for the
**
U2 firm will be ***
U1
***
Owner’s constraint

Benefits
b* b**

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The Principal-Agent Relationship

The firm’s owners are harmed by

having to rely on an agency relationship
with the firm’s manager
The smaller the fraction of the firm that
is owned by the manager, the greater
the distortions that will be induced by
this relationship

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Incentives Contracting
A worker is hired by a principal to do a
task.
Only the worker knows the effort she
exerts (asymmetric information).
The effort exerted affects the principal’s
payoff.

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Incentives Contracting
The principal’s problem: design an
incentives contract that induces the
worker to exert the amount of effort
that maximizes the principal’s payoff.

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Incentives Contracting
e is the agent’s effort.
Principal’s reward is
y  f (e).
An incentive contract is a function s(y)
specifying the worker’s payment when
the principal’s reward is y. The principal’s
profit is thus
 p  y  s ( y )  f (e)  s ( f (e)).
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Incentives Contracting
Let u ~ be the worker’s (reservation)
utility of not working.
To get the worker’s participation, the
contract must offer the worker a utility
of at least u~.
The worker’s utility cost of an effort
level e is c(e).

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Incentives Contracting
So the principal’s problem is choose e to
max  p  f ( e )  s ( f ( e ))

subject to s( f ( e ))  c ( e )  u~ . (participation
constraint)

To maximize his profit the principal designs the

contract to provide the worker with her
reservation utility level. That is, ...

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Incentives Contracting
the principal’s problem is to
max  p  f ( e )  s ( f ( e ))

subject to s( f ( e ))  c ( e )  u~ . (participation
constraint)

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Incentives Contracting
the principal’s problem is to
max  p  f ( e )  s ( f ( e ))

subject to ~. (participation
s( f ( e ))  c ( e )  u
constraint)
Substitute for s( f ( e )) and solve
max  p  f ( e )  c ( e )  u~ .

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Incentives Contracting
the principal’s problem is to
max  p  f ( e )  s ( f ( e ))
~.
s( f ( e ))  c ( e )  u (participation
subject to constraint)
Substitute for s( f ( e )) and solve
max  p  f ( e )  c ( e )  u~ .

The principal’s profit is maximized when

f ( eAndualem ( e ).
)  cBegashaw 20
Incentives Contracting
f ( e )  c( e )  e  e * .
The contract that maximizes the principal’s
profit insists upon the worker effort level e*
that equalizes the worker’s marginal effort cost
to the principal’s marginal payoff from worker
effort.
How can the principal induce the worker
to choose e = e*?
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Incentives Contracting
e = e* must be most preferred by the
worker.
So the contract s(y) must satisfy the
incentive-compatibility constraint;

s( f (e*))  c (e*)  s( f (e ))  c ( e ), for all e  0.

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The End

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