Lecture12 - 13 - agency moral hazard adverse selection


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Unformatted text preview: reach higher expected profits. But the flat wage does not work 12 Hidden action: effort not observable Consider compensation contingent on profits: w(π) The agent receives wH if profits are high and wL if they are low, where wH > wL. The agent chooses eЄ[eL, eH] to Max U(e; w(π)) = w(π) – e Suppose he chooses eL. Then his expected utility is: E(U/eL) = pL * wH + (1­ pL) * wL – eL Suppose he chooses eH. Then his expected utility is: E(U/ eH) = pH * wH + (1­ pH) * wL – eH He will exert eH only if (incentive compatibility constraint) pH * wH + (1­ pH) * wL – eH ≥ pL * wH + (1­ pL) * wL – eL (6) He will accept the contract only if (participation constraint) pH * wH + (1­ pH) * wL– eH ≥ 0 (7) 13 Hidden action: effort not observable Thus, the principal’s problem is to choose the payment scheme (w H, wL) that induces the agent to accept the contract and exert high effort. If there is a pair (wH, wL) such that both (6) and (7) are satisfied, then by offering this contract the principal induces the agent to exert effort and achieves expected profits: E(profit) = E(π) – w = pH * (πH –wH) + (1...
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This document was uploaded on 03/09/2014 for the course COMM 371 at The University of British Columbia.

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