Perloff_397614_IM_Ch19 - Chapter 19 Contracts and Moral...

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Chapter 19 Contracts and Moral Hazards ± Chapter Outline 19.1 Principal-Agent Problem A Model Types of Contracts Efficiency 19.2 Production Efficiency Efficient Contract Full Information Asymmetric Information 19.3 Trade-Off Between Efficiency in Production and in Risk Bearing Contracts and Efficiency Choosing the Best Contract 19.4 Payments Linked to Production or Profit Piece-Rate Hire Contracts Contingent Contract Rewards Linked to a Firm’s Success 19.5 Monitoring Bonding Deferred Payments Efficiency Wages After-the-Fact Monitoring 19.6 Contract Choice ± Teaching Tips Chapter 19 continues the discussion started in Chapter 18 on information asymmetry. While it is not necessary to cover all of Chapter 18 before Chapter 19, it will be helpful if the class is familiar with at least the introductory portion of Chapter 18. However, the material is not difficult, and need not be saved for the end of the semester if you are interested in including it earlier. For example, one logical place to discuss principal agent problems is while covering the factor markets (Chapter 15). By doing so, you can contrast labor markets at the aggregate level with labor contracts at the individual level.
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248 Perloff • Microeconomics: Theory and Applications with Calculus One of the keystones of the material in this chapter is incentive compatibility. You might suggest to the class that whenever they are evaluating an individual level transaction, one of the prerequisites to sound analysis is to check the incentives of the buyer and the seller. For example, does the seller expect repeat sales in which reputation will be important, or are all sales to one-time customers who won’t have much recourse or ability to spread negative information if ripped off? Do the buyers have any incentive to claim that they are part of one group (e.g., healthy individuals) when they are not, as in the case of insurance? By beginning the discussion in this way, you should be able to lead the class directly to the importance of information, and the opportunity for moral hazard problems to arise when information is asymmetric. The optimal contract type depends on the level of uncertainty and symmetry of information between buyer and seller. Possible arrangements include piece rates, fixed fees, hourly rates, and contingent fees. You might present the class with a number of transactions and ask them to decide what is the best type of contract. They may find that in many cases, the seller would prefer one type of contract and the buyer another, and a compromise between efficiency and risk bearing must be sought. The text includes such an example of Pam, who is injured in a car accident, and her attorney, Alfredo. Another example is a professional athlete and team owner. The athletes would like for the contract to be guaranteed, so that no matter what the performance level is, he or she receives payment. Employers (teams) would prefer to pay employees based on performance.
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This note was uploaded on 11/03/2009 for the course ARE 100A taught by Professor Constantine during the Spring '08 term at UC Davis.

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Perloff_397614_IM_Ch19 - Chapter 19 Contracts and Moral...

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