Topic 15 AgencyProb

Topic 15 AgencyProb - Topic 14 Topic 15: Agency Problem...

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Topic 14 Topic 15: Agency Problem t K S h t h Ratna K. Shrestha
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The Principal-Agent Problem The principal agent problem arises under asymmetric information f th “hidd ti ” t ll d M l H d p g of the “hidden action” type called Moral Hazard. A principal hires someone – an “agent” but cannot fully observe r at least cannot legally verify the action of the agent. In this case o e s c o eg y ve y e c o o e ge . sc se the agency has an incentive to shirk or cheat or agency has no incentives to work in the interest of the principal. This is sometimes lled simply the “ ency” problem 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 if this effort cannot be monitored, then the manager has no incentives to work hard (as agent’s objective does not coincide with the principal’s objective). THE UNIVERSITY OF BRITISH COLUMBIA
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An Example of an Agency Consider the following example. The manager’s effort is Problem 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 igh Effort 0 00 High Effort 60 100 The cost of low effort is 10, the cost of high effort is 20. ,g Probability of bad luck is 0.6 and that of good luck is 0.4. The manager and the owner are both risk-neutral, so they both care nly about expected incomes. THE UNIVERSITY OF BRITISH COLUMBIA only about expected incomes.
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Example 1 cont’d p Assume two possible contracts: (a) a fixed wage of $20 or (b) profit sharing which gives the manager 50% of the income.
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Topic 15 AgencyProb - Topic 14 Topic 15: Agency Problem...

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