Lecture12 - 13 - agency moral hazard adverse selection

Theprincipalsproblemistodesignanincentivepaymentfromth

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Unformatted text preview: is determined at least in part (but not fully) by the unobservable actions that the agent takes. Note that by observing the realization of the output variable, the principal cannot infer the action taken by the agent. The principal’s problem is to design an incentive payment from the principal to the agent that induces the agent to take the best action from the viewpoint of the principal. 7 Formal Treatment in a Simple Example An example of a principal­agent problem is that of a firm’s owners hiring a manager to run the firm on their behalf. The principal (the owners) hire the agent (the manager) to exert effort, e, in running the company. Effort generates profits (before paying the manager) that depend on the agent’s effort and a random variable. The agent can work hard (eH) or shirk (eL), with eH > eL. If the agent exerts eH, then profits will be πH with prob. pH and πL with prob. 1­pH. If he exerts eL, profits will be πH with prob. pL and πL with prob.1­pL. Note that effort increases the chances of high profits: pH>pL. The...
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