Principal-Agent Models

Laffont, J.-J. and D. Martimort [2002] The Theory of Incentives, Princeton Univ. Press Salani B. [1997], The Economics of Contracts, A Primer, MIT, Cambridge MA: ch. 2 (2.1, 22.), pp. 11-26

What is P-A-theory about?

Why is health insurance so expensive? Why does nobody pay me for what I am really worth? How much should I bid for this oil field? Should insurance companies be allowed to check my genes before offering me a contract? Why are there banks (and other financial intermediaries)?

Why principal-agent?
One party (the principal) contracts another party (the agent) to perform some action or to take some decision. The agent has an information advantage he knows something the principal does not know, will know something the principal does not know, he can take secret actions. The principal knows that the agent has this advantage (making it a potential handicap!).

Examples
owner manager insurance company insured creditor debtor firm salesmen voters government investor portfolio manager

Two basic stories

Story 1
t=0 A discovers his type

Hidden Information
t=1 P offers a contract t=2

Adverse Selection
t=3 time The contract is executed

A accepts or refuses

Story 2
t=0 P offers a contract

Hidden Action
t=1 A accepts or refuses t=2

Moral Hazard
t=3 time A exerts an effort or not The outcome is realized and the contract is executed

Source: Laffont und Martimort (2002)

Adverse selection
You consider buying a second hand vehicle. You know that there are different qualities the cars' owners know their car's quality you cannot distinguish cars Owners do not sell for less than the true value You do not bid more than the expected value What will happen?

Case 1: two qualities

50% good: 50% bad:
E[V] 10000

Value = $ 10000 Value = $ 5000

45

V = 7500 5000 Quantity=50%

E[V | V p] Partial market failure but no efficiency loss

5000

10000

Price offered

Case 2: Continuum of qualities

Uniform distribution of values between $ 5'000-10'000
E[V] 10000 45

V = 7500 5000

E[V | V p]

5000

10000

Price offered

Case 2: Continuum of qualities

Uniform distribution of values between $ 5'000-10'000
E[V] 10000 45

V = 7500 5000 Quantity = 0

E[V | V p] Total market failure but no efficiency loss

5000

10000

Price offered

Case 3: Gains from trade

Value for seller uniform distribution between $ 5'000-10'000 a = valuation buyer / valuation seller = vb/ vs = 1.2
E[V ]
b

45

10000 E[aVs | Vs p]

5000

5000

7500 10000

Price offered

Case 3: Gains from trade

Value for seller uniform distribution between $ 5'000-10'000 a = valuation buyer / valuation seller = vb/ vs = 1.2
E[V ]
b

45

10000 1.2 6'250 = 7500 5000 Quantity=50% E[aVs | Vs p]

5000

7500 10000

Price offered

Case 3: Gains from trade

Value for seller uniform distribution between $ 5'000-10'000 a = valuation buyer / valuation seller = vb/ vs = 1.2
E[V ]
b

45

10000 1.2 6'250 = 7500 5000 Quantity=50% E[aVs | Vs p] Partial market failure Efficiency loss best cars not optimally used (worst cars subsidized)

5000

7500 10000

Price offered

Case 3: Gains from trade

Value for seller uniform distribution between $ 5'000-10'000 a = valuation buyer / valuation seller = vb/ vs = 1.2
E[V ]
b

45

10000 1.2 6'250 = 7500 5000 Quantity=50% E[aVs | Vs p] Partial market failure Efficiency loss best cars not optimally used (worst cars subsidized) Higher a smaller range of qualities unsold higher efficiency loss for best cars

5000

7500 10000

Price offered

Preliminary conclusion
Informational asymmetries create inefficiencies. Quantities traded are smaller than under first best; market may fail completely. Less informed party knows that they know less and anticipate opportunistic behavior by better informed party. The information advantage is a handicap for the owners of the best qualities. is an advantage for the owners of the worst qualities (they can hide behind the intermediate qualities). The presence of bad cars creates a negative externality to the owners of good cars.

Optimal contracts
an attempt to overcome informational asymmetries one party proposes contract (mostly principal) the counterparty accepts or rejects contract creates incentives: good types accept, bad types reject (hidden info) exert effort (hidden action) mechanics: offering party maximizes utility subject to constraints: participation incentives wealth, feasibility

Rain in Bilbao
For several months not a drop of rain has fallen in Bilbao. The desperate mayor is contacted by a sourcerer who says he is able to make rain. If the sourcerer is a bluffer the chance of rain for the next week stays at 2/100. If he really is a sourcerer, the chance of rain goes up to 20/100. The pretending sourcerer has a utility function of u(w) = w0.5. If he is a sourcerer, he accepts a contract if he gets at least u=10. If he is a bluffer, he accepts if he gets u>1. The mayor does not want to be caught with a bluffer. a) What contract should the mayor offer? b) What is the cost of the information asymmetry to the city of Bilbao?
Source: I. Macho-Stadler und J.D. Perez-Castrillo, An Introduction to the Economics of Information, Oxford University Press, 1977, p. 161

The solution in a nutshell

With what type of agent do you want to work? sourcerer: yes bluffer: no Find all contracts that the sourcerer accepts the bluffer rejects Choose the cheapest of these contracts and offer it on a take-it-or-leave-it basis Compare cost of contract to cost of the cheapest contract under symmetric information: Difference is cost of information asymmetry.

Hidden Information: Game Tree

offer contract c

good type

bad type

c EU(c)

reject EU(rej)

c EU(c)

reject EU(rej)

How to get the good type only?

offer contract c

good type

bad type

c EU(c)

reject EU(rej)

c EU(c)

reject EU(rej)

Participation Constraints

pro memoria: assumptions

Agent's utility: u = w0.5 Agent accepts contract: - sourcerer: if uS 10 = uS - bluffer: if uB > 1 = uB p(R|S) = 0.20 p(R|B) = 0.02

contract space
Contracts can define payments that are contingent on observable (and verifiable) outcomes. Type of agent (S, B): not observable (not even ex post) Outcome (R, 0): observable Contract can specify payments for R and 0. This is the contract space. The principal should use her contract space. The general form of the contract thus is c = {wR, w0} The optimal contract c* = {w*R, w*0} maximizes the principal's utility subject to constraints (S accepts, B rejects)

Participation constraints
Sourcerer: Bluffer: 0.20(wR 0.5) + 0.80(w0 0.5) 10= uS 0.02(wR 0.5) + 0.98(w0 0.5) 1 = uB

both constraints bind, because if not - for sourcerer: we could have him cheaper
- for bluffer: sourcerer bears unnecessary risk (we could make outcomes more similar, thus paying sourcerer less in expected terms)

Graphical solution
w0
45

uB uS 0 uB 2500 uS

wR

Numerical solution
Optimal contract when types are unobservable: w*R = 2500, w*0 = 0 Optimal contract when types are observable (first best): wf = wR = w0 = 100 (only offered to sourcerer) The cost of the information asymmetry? Cost = Ew* Ewf = 0.2(2500) -100 = 400 is here paid by the principal.

The example is a bit too simple

negative payments are excluded by assumption (utility is a function of square root of w). The bluffer is useless by definition => the principal does not need to look at menus with a contract for each type It pays to hire the sourcerer by definition Only one contract satisfies both constraints => this contract is automatically the optimal contract => the principal's objective function is passive

The general case

Four cases: hire S, B, both or neither? What is the optimal contract for each case?
(cheapest contract that attracts exactly the targeted type(s))

Which of the four optimal contracts maximizes the principal's utility? => the overall optimal contract

Our example slightly modified

Utility: Participation: - sourcerer if: - bluffer if: u = w0.5 uS 20 = uS uB > 11 = uB

Graphical solution
w0 OF
45

100 uB 0 3600 uS

wR

Numerical solution
Optimal contract when types are unobservable: w*R = 3600, w*0 = 100 Interpretation:
performance wage 100 = fixed wage; 3500 = bonus for rain 3600 = fixed wage; 3500 = penalty if no rain

Examples
Guarantee Health Insurance: Franchise Mortgage Credit Baby 81 King Salomo's Judgement

Two basic stories

Story 1
t=0 A discovers his type

Hidden Information
t=1 P offers a contract t=2

Adverse Selection
t=3 time The contract is executed

A accepts or refuses

Story 2
t=0 P offers a contract

Hidden Action
t=1 A accepts or refuses t=2

Moral Hazard
t=3 time A exerts an effort or not The outcome is realized and the contract is executed

Source: Laffont und Martimort (2002)

Hidden Action: Game Tree

offer contract c

accept

reject

effort Incentive Constraint

no effort

EU(eff) EU(no) Participation EU(acc+eff) EU(acc+no) Constraints

<

EU(reject) EU(reject)

Our example modified once more

The mayor only faces one person. He is a sourcerer, but only increases the probability of rain if he exerts a special effort. Utility: u = w0.5 e Participation if: u 11 = u Cost of effort: e=9

Hidden Action: Result

The optimal contract is only "second best": Agent must bear some risk as an incentive. If he is more risk averse than the principal, this means a cost (often paid by the principal). Optimal effort level under hidden effort is normally smaller than under observable effort

Exercise: Incentive Contract

You ask a broker to sell some real estate for you. The outcome is either good ($ 50'000) or bad ($ 25'000) The broker can influence the outcome by exerting effort: effort e1 (low) e2 (medium) e3 (high) cost of e (utility units) probability ($ 50'000) probability ($ 25'000) 5 25 75 20 50 50 40 75 25

You cannot observe the broker's effort, but you observe the outcome (the price at which you can sell). You are risk neutral (i.e. you maximize expected profit) The broker maximizes U = w1/2 - e, where w is financial income and e effort cost. He only becomes active if he gets U=120 What contract do you offer the broker? What are the effects of unobservability of effort?

Hints:
What are the best contracts for each possible effort level when effort is not observable? (Draw the constraints in a graph with w1/2-axes!!!) Which among these best contracts yields the highest profit overall? What effort level would P want to get if effort was observable? What contract would he offer? What difference does unobservability make on: the optimal effort level? A' welfare? P's welfare?

A contract design intelligence test

A big law firm is interested to invite you to give a lecture on Contract Design.You are supposed to make a proposal as to a speaker's fee, but you are quite uncertain about what they are ready to pay. You value your best alternative (leisure or lecturing somewhere else) to $ 10'000. What do you propose if you maximize your expected fee also try show that you know some contract theory assume that their valuation is V~U[0,50'000]

Hints:
An important idea in the economics of contracts (or: mechanisms) is the Revelation Principle The Revelation Principle says (roughly): whatever outcome you can achieve, you can achieve by giving the counterparty an incentive to tell the truth. you do not loose anything by making the counterparty tell the truth. Example: the second price auction (also Vickrey auction): the highest bidder gets the good for the amount of the second highest bid

What is P-A-theory about?

Why is health insurance so expensive? Why does nobody pay me for what I am really worth? How much should I bid for this oil field? Should insurance companies be allowed to check my genes before offering me a contract? Why are there banks (and other financial intermediaries)?