MGMT 104 Lecture Notes - Lecture 2: Risk Aversion, Adverse Selection, Problem Domain
Document Summary
Risk-sharing problem- arises when the cooperating parties have different attitudes toward risk; includes agency problem. Agency relationship- one party (principal) delegates work to another (agent) who performs that work. Information assumptions: information as a purchasable commodity o: contracting problems: agency (moral hazard and adverse selection), risk sharing o. Problem domain: relationship in which the principal and agent have partly differing goals and risk preferences. Focus is on relationship between owners and managers of large, public corporations behavior and the cost of measuring outcomes and transferring risk to the agent. Proposition 1: when the contract between the principal and agent is outcome based, the agent is more likely to behave in the interests of the principal. Outcome-based contracts are effective in curbing agent opportunism, because these contracts co- align the preferences of agents and principals. Proposition 2: when the principal has information to verify agent behavior, the agent is more likely to behave in the interest of the principal.
