ECON 426 Lecture Notes - Lecture 25: Risk Neutral, Moral Hazard, Expected Utility Hypothesis
13 Jun 2018
School
Department
Course
Professor
Dis mans got his lectures mixed up
Hey, corporations are people too, you know :/
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The Firm: More than a Production Function
e.g. mortgage contracts, sales contracts…
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Formal contracts specify exactly what each partner to the contract has to do
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Incomplete - the employment relationship is too complex to specify exactly what the requirements
are in each situation
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Too vague to be legally enforceable
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Implicit - employment contract are often pretty vague about what's required
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Employment contracts are typically:
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This means that both sides to the contract need to find it in their interest to adhere to the terms of
the contract once the relationship is established
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→Employment contracts need to be self-enforcing
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Employment Contracts
The problem is often that one partner has more information about a situation than another:
information is asymmetric
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If everything was known to both partners to the contract, then contracts could explicit or implicitly
stipulate what has to happen in every eventuality
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The worker (agent) knows what actions they're taking in different situations
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The employer (principal) only has a fuzzy understanding of what the agent is up to
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The gives rise to the…dun dun dun… PRINCIPAL-AGENT theory
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We will consider the problem of moral hazard:
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The Problem: Asymmetric Information
Owners want to maximize profit
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Employees want to maximize their own utility
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The interests of firm owners (principal) and employees (agents) aren't aligned
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Owners might direct employees what to do
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The problem is that works have "private information" on their actions
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How do they resolve this conflict?
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This conflict of interest + asymmetric information is at the core of modern theory on incentives
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The Basic Conflict
Why might employees dislike have their compensation vary a lot with performance?
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Does it matter whether employees dislike performance pay?
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Why Might…
Affects output
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Generates effort cost to the Agent
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Is unobserved by the Principal
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e = agent's effort
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Related to effort
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Output y doesn't perfectly reveal e →there's randomness in y
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We will model this as where = 0
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The principal only observes output y
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The principal sets a salary s(y)
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The worker has an outside option of
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A Simple Formulation of the Problem
E[y - s]
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The principal just cares about expected profit - they're risk neutral
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The Agent cares about:
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Preferences
Lecture 25 - Incentives
Wednesday, April 18, 2018
10:19 PM
ECON 426 Page 1
Document Summary
Hey, corporations are people too, you know :/ Formal contracts specify exactly what each partner to the contract has to do e. g. (cid:373)ortgage co(cid:374)tracts, sales co(cid:374)tracts . Incomplete - the employment relationship is too complex to specify exactly what the requirements are in each situation. Implicit - employment contract are often pretty vague about what"s required. This means that both sides to the contract need to find it in their interest to adhere to the terms of the contract once the relationship is established. If everything was known to both partners to the contract, then contracts could explicit or implicitly stipulate what has to happen in every eventuality. The problem is often that one partner has more information about a situation than another: information is asymmetric. We will consider the problem of moral hazard: The worker (agent) knows what actions they"re taking in different situations. The employer (principal) only has a fuzzy understanding of what the agent is up to.
