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Lecture12 - 13 - agency moral hazard adverse selection


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Unformatted text preview: ts for the principal after managerial pay: E(profit/eH) = E(π/ eH) – w = pH * πH + (1­ pH) * πL – wH (3) E(profit/eL) = E(π/ eL) – w = pL * πH + (1­ pL) * πL – wL (4) Suppose E(profit/ eH) > E(profit/ eL), i.e., the principal wants the agent do eH. He then sets a compensation scheme wH ≥ eH and wL < eL. Thus, the agent will accept the contract and exert eH. The principal pays wH = eH and the agent gets zero utility (pay the agent just enough to induce him to accept the job) 11 Hidden action: effort not observable Consider first a flat wage w(π) = w ≥ eH, which is the same regardless of profits. The agent will be willing to accept the job and exert high effort (but may choose to exert eL) Taking the flat wage w offered by the principal as given, the agent will secretly choose eЄ[eL, eH] to Max U(e;w) = w – e The agent will accept the contract, choose eL, and will always reach utility U(eL;w) = w – eL > 0. The principal’s expected profit will be: E(profit/w) = E(π) – w = pL * πH + (1­pL) * πL – w (5) If firm owners could induce the manager to exert more effort, then often they would...
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