10-28-09-(2)

10-28-09-(2) - Economics 448 Class Notes Contract Design...

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Economics 448 – Class Notes – 10/28/09 Contract Design Example taken from David Kreps (1990) – A course in Microeconomic Theory FROM THE PACKET: First best contract : A contract that happens in a “first-best world.” If it doesn’t happen in a first- best world, you are not getting a first-best contract. This talks about how the world works. A contract that maximizes the principal’s expected profit subject to the participation and incentive constraints, but does not pay the agent anything greater than the participation constraint. APPLIES WHEN: o No hidden hinformation: Principals know the expected outcome of the agent taking a particular action o No hidden action: principal can fully boserve actions and outcomes o No risk: agents are risk neutral or bear little risk. FIRST-BEST WORLD: * There are zero transaction costs * No risk * NOT REALISTIC –we don’t live in a first-best world KEY: First-best contract happens in a first best world Second best contract : A contract that maximizes the principal’s expected profit subject to the participation and incentive constraints. This contract might pay the agent more than the first best contract, or it might induce the agent to make a different level of effort than the first best contract. It offers the best balancing act from the princpal’s perspective between risk and incentives. Generally: We live in a world where it is hard to monitor effort, Agents DON’T like risk You have to incentivize agents Idea: we cannot get to a better contract (first-best world) HIGH VS. LOW POWERED INCENTIVES – SEE POWERPOINT SLIDE
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High powered contract - incentivized Low powered contract – flat salary HIGH POWERED LOW POWERED Risk aversion Less likely More likely Effort aversion Less likely More likely High marginal contribution of effort to output More likely Less likely Easily measurable performance More likely Less likely If you are REALLY effort averse, you are going to give the contract that is low powered
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This note was uploaded on 01/07/2010 for the course ECON 448 taught by Professor Nonnenmacher during the Fall '07 term at Allegheny.

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10-28-09-(2) - Economics 448 Class Notes Contract Design...

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