More Fun with the Principal-Agent Model

Christopher Makler

Stanford University Department of Economics

 

Econ 51: Lecture 18

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A reminder...

If people have hidden information,
(e.g. the quality of a used car for sale)
what mechanism can a designer establish
to get them to reveal that information?

If people can take hidden actions,
what mechanism can a designer establish
to get them to choose the action the designer wants them to take?

ADVERSE SELECTION

MORAL HAZARD

Principal: Someone who needs someone else to do something

Agent: The person who needs to do the thing

CEO / sales rep

Professor / student

Landowner / farmer

The principal's payoff depends on the actions of the agent

Can they incentivize the agent to do what they want?

Principal-Agent Model

The agent can choose whether to exert effort (E), shirk/not exert effort (N), or reject the contract altogether (R)

Their effort choice is unobservable to the principal.

Model 1 (Last time): Discrete choice of effort

The principal's problem is to choose a wage structure that maximizes their own expected payoff

If they want to get the agent to choose E, they need to make choosing E the best choice:

Incentive compatibility constraint: E must be at least as good as N

Participation constraint: Accepting the contract (and exerting effort E)
must be at least as good as rejecting it (R).

The agent chooses how much effort to exert.

Their effort choice is unobservable to the principal.

Model 2: Continuous choice of effort

The principal's problem is to choose a wage structure that maximizes their own expected payoff

Their problem is to choose the wage contract that incentivizes the agent to choose the profit-maximizing E*

The principal is an insurance company; the agent is someone they insure.

The agent's "effort choice" is how safely or riskily to behave

Model 3: Moral hazard and insurance deductibles

If the insurance company fully insures the agent, there's no incentive to behave in a safe manner.

Their problem is to choose the an insurance contract which offers some insurance (both of them are better off) but not so much that the agent behaves recklessly.

Econ 51 | 18 | More Fun with the Principal-Agent Model

By Chris Makler

Econ 51 | 18 | More Fun with the Principal-Agent Model

How to design a mechanism to get someone to behave a certain way, or to reveal their true preferences

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