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Chapter 15

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Yasin Janjua

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 revealed. Moral hazard problem occurs when an agent’s action is private information and it is not known how they work or act. Automobile insurance 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) 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 ensures that 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 Marginal If the shareholders could specify the manager’s effort Profit profit,MC Effort cost 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 profit. 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 2 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 . incentive scheme. Although the shareholders cannot observe effort
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