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Lecture12 - 13 - agency moral hazard adverse selection


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Unformatted text preview: agent’s effort is not observable to the principal, but the principal observes the final profits. 8 Formal Treatment (cont.) Effort eH Profit πH Prob. pH eH πL 1­pH eL πH pL eL πL 1­pL We observe πH: can we be sure that the agent exerted eH? We observes πL: can we be sure that the agent exerted eL? How can the principal design a contract that the agent accepts and induces him to exert high effort? The principal cannot choose effort: he can only influence the agent’s effort choice by his choice of incentive payment. 9 Formal Treatment (cont.) Payoff to the agent: The agent’s utility when he receives a payment w and exerts effort e is given by: U(e;w) = w – e (1) Payoff to the principal The principal’s expected profits after payment to the agent are given by: E(profit/e) = E(π/e) – w (2) 10 Full information: effort is observable The principal must decide whether the agent should exert eH or eL, and design pay to induce him to choose that action. Principal will pay wH after observing eH and wL after eL. Expected profi...
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