Monitoring, Management, Compensation, and Regulation Chapter 15. Principle and agent Organization: Markets and strategies ② Wen cao
Slides Reference: Industrial Organization: Markets and Strategies © Wen Cao Monitoring, Management, Compensation, and Regulation Chapter 15. Principle and Agent
Chapter 15-Objectives Chapter 15. Learning objectives Understand Moral hazard and Adverse Selection Understand principle-agent issue e Wen Cao
© Wen Cao 2 Chapter 15- Objectives Chapter 15. Learning objectives • Understand Moral Hazard and Adverse Selection. • Understand principle-agent issue Chapter 15. Learning objectives • Understand Moral Hazard and Adverse Selection. • Understand principle-agent issue
Chapter 15-Information Asymmetry Moral hazard issue ° Examples o Parents do not know whether kids prepare homework Owners do not know whether management shirks Hidden action vs hidden characteristics Design payment scheme to provide incentive to exert effort . Owner proposed a payment scheme(contract)that depends on observed output NoT effort e Worker accept or reject contract and choose optimal effort leve The Owner pays the worker based on realized output e Wen Cao
© Wen Cao 3 Moral Hazard Issue • Examples • Parents do not know whether kids prepare homework • Owners do not know whether management shirks • Hidden action vs hidden characteristics • Design payment scheme to provide incentive to exert effort. • Owner proposed a payment scheme (contract) that depends on observed output NOT effort • Worker accept or reject contract and choose optimal effort level. • The Owner pays the worker based on realized output. Chapter 15 – Information Asymmetry
Chapter 15-Information Asymmetry Principle-Agent Problem e Model Agent can choose to work hard e=2, or not e=0 Agent's reservation utility=10 w-e if he devotes an effort level 0 if he works at another place (15.1) e Owners profit f(agents unobserved effort)-wage payment R()-{B=2 ife=0.≡R(e) (153) Participation constraint: -accept the contract 2≥10 (154) Incentive constraint: work hard> no effort -2≥u2-0. (155) Contract: W(=12, WL=10. No uncertainty! e Wen Cao
© Wen Cao 4 Principle-Agent Problem • Model • Agent can choose to work hard e=2, or not e=0. • Agent’s reservation utility=10. • Owners profit = f(agent’s unobserved effort) – wage payment • Participation constraint: - accept the contract • Incentive constraint: work hard > no effort • Contract: w(H)=12, w(L)=10. No uncertainty! Chapter 15 – Information Asymmetry
Chapter 15-Information Asymmetry Principle-Agent Problem with uncertainty Model e Agent can choose to work hard e=2, or not e=0 Outcome is uncertain R(2-H probability 0.8 and R(O) H probability 0.4 L probability 0.6. 6) Agents reservation utility=10 U-{5m-· he devotes an e level of effort(57 o Owners profit f(agents unobserved effort)-wage payment R(e)= H ife=2 t= R(e)- L ife=0 (153) e Participation constraint:-accept the contract 2≥10 e Incentive constraint work hard> no effort 08u+02u-2≥0.4u+0.6-0. (159) Contract:W(H)=13>12,w(l)=8<10
© Wen Cao 5 Principle-Agent Problem with uncertainty • Model • Agent can choose to work hard e=2, or not e=0. • **Outcome is uncertain • **Agent’s reservation utility=10. • Owners profit = f(agent’s unobserved effort) – wage payment • Participation constraint: - accept the contract • Incentive constraint: work hard > no effort • Contract: w(H)=13>12, w(L)=8<10. Chapter 15 – Information Asymmetry
Chapter 15-Risk Aversion The principle and agent can have different degree of risk aversion Definitions Two consumers i andj. Consumer i is more risk averse than consumer j, when consumer j prefers a fixed sum of money over a lottery, then consumer I also prefers the fixed amount °n0-{zm8rPo-{m probability 0.7 R(o)=R°().(1511 Waiter is more risk averse than the owner as he is more sceptical about realization of high state Payoff functions PC:0n+034-20.mwm12-03y2.(5y C:0+032-2041+02-0.mu=203+.(513
© Wen Cao 6 The principle and agent can have different degree of risk aversion • Definitions • Two consumers i and j. Consumer i is more risk averse than consumer j, when consumer j prefers a fixed sum of money over a lottery, then consumer I also prefers the fixed amount. • • • Waiter is more risk averse than the owner, as he is more sceptical about realization of high state. • Payoff functions: PC: IC: Chapter 15 – Risk Aversion
Chapter 15-Risk Aversion The principle and agent can have different degree of risk aversion Owner's expected payment: Jm n. ow=0. 8u+0. uc (1514) 15.12 PC, 15.13 C, 15.14, owner's payoff 1513) (1514) WH=14,WL=223(ws12/10,vs13/8) EW=14*08+22/3*0.2=12.66>12 Need to compensate more when waitress is more risk averse e Wen Cao
© Wen Cao 7 The principle and agent can have different degree of risk aversion • Owner’s expected payment: • 15.12 PC, 15.13 IC, 15.14, owner’s payoff • WH=14, WL=22/3 (vs 12/10, vs 13/8) • EW=14*0.8+22/3*0.2=12.66>12 Need to compensate more when waitress is more risk averse. Chapter 15 – Risk Aversion
Chapter 15- Team Production Optimal Team Effort- free rider problem Output depends on teams joint effort (1515) U≡-e,i=1,2,……,N Optimal effort level WEVIN v Nve N°e*=14V*=N2 o Equal-division Economic Mechanism maxU-N--e4, implying that e"=*4Na Se (1518) When n=1. e=e When n>=2, e<e when n increases ower effort from each individual To solve this problem w- V"/N if EM, VE-y
© Wen Cao 8 Optimal Team Effort – free rider problem • Output depends on team’s joint effort: • • Optimal effort level w=V/N e*=1/4 V*=N/2 • Equal-division Economic Mechanism • • When N=1, e=e*, When N>=2, e<e*, when N increases, lower effort from each individual. • To solve this problem Chapter 15 – Team Production
