c295%20Week%2012b%202010

c295%20Week%2012b%202010 - The Principal-Agent Problem...

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THE UNIVERSITY OF BRITISH COLUMBIA These notes build on the model of managerial compensation that was presented and briefly discussed in Lecture 4 (Sept. 30, 2010) These notes were prepared by Professor Jim Brander, who instructs section 103 of COMM 295. He generously shared his notes with the other COMM 295 instructors for this particular chapter The Principal-Agent Problem
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THE UNIVERSITY OF BRITISH COLUMBIA A principal hires someone – an “agent” but cannot fully observe or at least cannot legally verify the action of the agent. This is sometimes called simply the “agency” problem. One important example occurs when the manager of the firm is the agent and the owner of the firm is the principal. The returns to the owner depend on the manager’s effort but this effort cannot be monitored The principal agent problem arises under asymmetric information of the “hidden action” type. The Principal-Agent Problem
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Consider the following example. The manager’s effort is given in the left column. Each cell shows the net income, I, to the firm (not subtracting the cost of effort): All numbers are in $ thousands Bad Luck Good Luck Low Effort 20 60 High Effort 60 100 The cost of low effort is 10, the cost of high effort is 20. Bad luck and good luck each have a 50% probability. The manager and the owner are both risk-neutral, so they both care only about expected values. There are two possible contracts, a fixed wage of 20 or profit sharing which gives the manager 50% of the income. An Example of an Agency
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c295%20Week%2012b%202010 - The Principal-Agent Problem...

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