Christopher Makler
Stanford University Department of Economics
Econ 51: Lecture 18
To the extent that this has been a good course, it's due in large part to the feedback I've gotten from students like you over the years.
Help me make it even better for the next group!
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?
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.
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.
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
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.