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Lecture 4

BU457 Lecture 4: Discussion – Agency Theory

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Wilfrid Laurier University
Bixia Xu

Discussion – Agency Theory -There are several important aspects of agency theory: o The information asymmetry caused by separation of ownership and control is an example of moral hazard. Agency theory, a branch of game theory, studies the problem of designing a contract to control moral hazard o The nature of most efficient contract depends crucially on what can be observed, and contracts can only be written in terms of performance measures that are jointly observable by both principle and agent ▪ If the agent’s effort can be jointly observed, a fixed salary is most efficient when the principal is risk-neutral (first-best) ▪ Usually, net income will not be realized until subsequent period but manager must be paid periodically, so compensation cannot be based on payoff ▪ If the agent’s effort cannot be jointly observed, but net income can, the most efficient contract may give agent a share of net income, but the payoff is risky and net income is a noisy measure ▪ If effort, payoff, and net income are all unobservable, the optimal contract is a rental contract, whereby the principal rents the firm to the manager for a fixed rental fee, thus internalizing the agent’s effort decision o The second-best contract is the contract that imposes the lowest amount
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