Eco205 Chapter 15 – Asymmetric Information 6 April 2013
Asymmetric information - In a game with uncertainty, information that one player has but the other does not
Principle – Agent Model
The game involves a contract signed between two players in an environment involving uncertainty. The player making
the contract offer is called the principal. The player who decides whether to accept the contract or not and then
performs under the terms of the contract is called the agent. The agent is typically the party with the private
information. The same party might be a principal in one setting and an agent in another
Adverse selection problem occurs when an
agent’s type is private information and not
Moral hazard problem occurs when an
agent’s action is private information and it
is not known how they work or act.
When selling a policy the company does not
know whether you are a high risk or low risk
driver (adverse selection)
Since you are insured you are less careful
Moral Hazard: Manager’s Private
Information About Effort
The moral-hazard problem is that the manager can increase the firm’s profit by working harder, but the shareholders
cannot observe the manager’s effort, and so the manager’s effort cannot be specified directly in a contract. Instead, the
shareholders will have to induce the manager to work hard through the design of the manager’s incentive contract,
which will link the manager’s pay to firm performance.
The setting can be modeled as a sequential game in which the shareholders move first, offering a contract to the
manager, and the manager moves second, deciding whether to accept the contract, and if the contract is accepted,
choosing how much effort to expend. We will use the subgame–perfect equilibrium concept, which in this context
1. the manager accepts the contract if it provides him or her with at least as high a payoff as the best alternative if
the contract were rejected; and
2. the manager chooses effort to maximize his or her utility, taking into account contractual pay and effort costs.
In other words, the manager works in his or her self-interest, not in the interest of the shareholders directly. The
manager only works in the shareholders’ interest indirectly if incentives are provided in the contract.
Full Information About Effort
If the shareholders could specify the manager’s effort Profit profit,MC
in a contract, they would choose the level e* Profit Lower MC
producing the highest joint surplus. In the upper Panel
panel, e* corresponds to the greatest distance
between the firm’s gross profit line and the Upper MP
manager’s effort cost curve. In the lower panel, e* is Panel
given by the intersection between the firm’s marginal
gross profit curve (MP) and the manager’s marginal e* Effort e* Effort Manager’s Effort: Unobservable Effort
effort cost line (MC). Manager’s S3– manager’s pay strongly
pay related to profit.
Manager’s Effort: Unobservable Effort
The steeper the slope of the incentive contract, also
called the ‘‘power’’ of the incentive contract, the more S2– manager’s pay moderately
related to profit.
closely the manager’s pay is tied to gross profit.
Line S 1orresponds to a constant wage that does not S – manager’s pay unrelated to
depend at all on how well the firm does. This incentive
contract has the lowest-possible power.
With lines S and S , the manager’s pay increases with
2 3 Profit
the firm’s gross profits. Line S has a moderate slope and thus is a moderate-powered incentive contract. The manager’s
pay increases with gross profit, but not very quickly. Line S is a high-powered incentive contract. The manager’s pay
© 2010 Manager’s Effort: Unobservable Effort. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
increases one-for-one with gross profit
The manager’s effort choice is given by the intersection Marginal MC
Under contract 1, the manager
of marginal pay and marginal effort cost. The marginal pay, cost exerts no effort,1e .
pay associated with constant wage scheme S leads t1
S3 Under contract 2, the manager
no effort; effort is increasing in the power of the exerts some effort, 2 .
Although the shareholders cannot observe effort