Class 21-20100 - C295 Class 21 The Agency Problem Today 1 2 3 4 5 6 7 8 Review questions on decision-making biases and on adverse selection

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11/25/2010 1 THE UNIVERSITY OF BRITISH COLUMBIA C295: Class 21 – The Agency Problem 1 Today: 1. Review questions on decision-making biases and on adverse selection. 2. Overview of the Agency Problem 3. Example 1 4. Example 2 5. Moral Hazard 6. Comments on the Principle-Agency Problem 7. Introduction to Market Failure 8. Summary THE UNIVERSITY OF BRITISH COLUMBIA Clicker Question 1 2 Prospect theory implies that the way a decision under uncertainty is framed affects the result because a. Framing can change the decision-maker’s perspective from thinking about a risky prospect as a potential loss to a potential gain. b. Most people are risk-averse over potential gains but risk-neutral over potential losses. c. Most people are overconfident (optimistic) when assessing probabilities. d. a. and b. e. All of the above.
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11/25/2010 2 THE UNIVERSITY OF BRITISH COLUMBIA Clicker Question 2 3 If buyers are uncertain about product quality while sellers know the product quality we have a situation of asymmetric information. The used car example indicates that asymmetric information of this type a. can cause buyers to be risk averse. b. can cause adverse selection. c. can cause inefficiency in that potential gains from trade are wasted. d. b and c. e. All of the above. THE UNIVERSITY OF BRITISH COLUMBIA A principal hires someone – an “agent” but cannot fully observe the action of the agent. Thus the agent knows what the he or she does but the principal is uncertain. 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 agency problem (often called the principal-agent problem) arises under asymmetric information of the “hidden action” type. 2. Overview of the Agency Problem
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11/25/2010 3 THE UNIVERSITY OF BRITISH COLUMBIA 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. 3. Agency: Example 1
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This note was uploaded on 01/19/2011 for the course COMMERCE 290 taught by Professor Brianogram during the Spring '09 term at The University of British Columbia.

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Class 21-20100 - C295 Class 21 The Agency Problem Today 1 2 3 4 5 6 7 8 Review questions on decision-making biases and on adverse selection

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