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Lecture 13

BU457 Lecture Notes - Lecture 13: Opportunity Cost, Information Asymmetry, Incentive Compatibility

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Bixia Xu

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Some Models of Cooperative Game Theory
Essence of cooperation is that the players in a conflict situation
can enter into agreements that they perceive as binding
o Such agreements are called contracts
Two important types of contracts that have implications for
financial accounting theory are:
o Employment contracts between the firm and its top
o Lending contracts between the firm manager and the
Agency theory is a branch of game theory that studies the
design of contracts to motivate a rational agent to act on behalf
of a principal when the agent’s interests would otherwise conflict
with those of the principal
Each party must be able to commit to the contract, that is, to
bind him/herself to “play by the rules”
Agency Theory: An Employment Contract Between Firm Owner
and Manager
The rational owner wishes to maximize the expected payoff, net
of manager compensation
Assume that the owner does not operate the firm and that this is
the responsibility of the manager
o Manager will be paid at year-end, despite the payoff not
being observable at that time
Assume also that, after being hired, the manager has two action
choices work hard, or shirk
The action of the agent affects the probabilities of the payoffs
o In particular, the greater the effort put into the operation
of the firm by the manager, the higher the probability of
the high payoff and the lower the probability of the low
o However, low payoff is still possible even if manager works
hard, and high payoff is possible even if the manager
If the manager is to be willing to work for the owner for the
current period, the compensation offered must be sufficiently
large that his/her expected utility is at least equal to its
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