2.2 Principal-Agent Problems in the Economy Flashcards Preview

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Flashcards in 2.2 Principal-Agent Problems in the Economy Deck (15):

Please, provide examples of ex-ante and ex-post opportunism in employment, loan, and lease contracts.

(2 for each type of contract and type of opportunism. (slides)

Employment contract:

  • Ex-ante opportunism - Hiding information on the tasks to perform, hiding characteristics of the employer and employee.
  • Ex-post opportunism – Hold-Up in the case of specific investments by the employer or by the employee and – Hidden action or hidden info on work efforts

Loan contract:

  • Ex-ante – A potential debtor knows his own economic prospects and his integrity better than his potential creditor does.
  • Ex-post – Debtors do not pay the money loan (money loan have high “plasticity” and makes the monitoring of debtors a costly process).

Lease contract:

  • Ex-ante - Lease of an apartment: the lessee visit the apartment on the weekend, when it is not loud.
  • Ex-post - Lease of an apartment: after the lessee has moved in, the lessor may seek to exploit the situation and raise the rent (enough to secure soma gains but not too high as to cause the lessee to move). Or the lessee does not have the same incentive as a full owner to use the property with care. 


How do transacting partners in a state of nature overcome the problem of transactional insecurity? (slides; Kronman 1985)

Hostages: provide something of value to hostage giver

  • Stock Breeder and Horse trader what to make an exchange. A horse for a cow. The cow can be delivered now but the horse will just be ready in 2 months. The horse trader gives a pile of wood (hostage), that he will need in winter, to assure that in two months the horse will be delivered.

Collateral: provide something of value to hostage taker

  • The stock breeder gives hay, that he need for feed the horse, and that will be given in return when the horse is ready 

Hands tying: Make breach of contract costly

  • Attaching a reputation to the exchange: The horse and the caw will be delivered, otherwise nobody will make transactions with you fail on your promise.

Union: increase likelihood that self-interested internally connected to others

  • In a certain community, the intentions are changed. If the stock breeder do not provide the caw, he will suffer the damages of non-commitment. The damage of someone else is putting on yourself => collective into transaction: both suffer the damage.



1. Hostages: “Give a hostage to hold until the performance is completed”. The hostage can be anything of the value to the hostage giver, thus the hostage giver has an incentive to keep his/her promise.
2. Collateral: In this case, the hostage has itself a direct use or exchange value. It can also have value to the hostage giver but not necessarily and this characteristic it is not what the hostage keeper care about. Its value is normally similar to the contracted good/service.
3. Hands tying: Similar to hostages but punishment to promisor is self-executing self-enforced hostages. E.g. preserving reputation to someone who keeps promises since this will increase the opportunities for other exchanges in the future. By making a public declaration, the harm will be worse if the agreement is not fulfilled.

4. Union: Persons with the same goals come together in unions. There is a minimized risk of opportunistic behavior. Parties can reduce the risk of opportunism by taking steps to increase the likelihood that each will see his own self-interest as being internally connected to the welfare of others. 


What conditions do we need for reputation to counterbalance the risk of market failure due to adverse selection?

Use an example. (slides; Furubotn et al. 2003 Ch5)

We already discussed about the market failure caused due to adverse selection, but we may counterbalance this risk by reputation.

According to the reputation equilibrium: ((1 + i)/i)(p1 - c1 ) ≥ p1 - c0 (i: constant interest rate!) OR p1 ≥ c1 + i(c1 - c0 ) That means that „the producer has an incentive to produce a high quality item only if high quality implies a rent that the producer is afraid of losing if he cuts the quality “ (Tirole 1988, p. 123)


In other words:

the benefit of selling a product with bad quality and a high price is possible only once (due the loss of reputation, it will not permit this transaction a second time).

The reputation premium may offer an incentive to supply quality, because the benefit of selling a product with high price and high quality is HIGHER than selling a bed quality product for a high price. 


If an enterprise is unable to distinguish between the capabilities of employees, what problem emerges and what wage (Löhne) will the enterprise pay its workers? (slides; Varian 2005)

If a company is unable to distinguish the capabilities of the employees, it will pays the average wage, that is too low for better qualify employees, whom worth higher prices.

This adverse selection results in too few transactions – if a buyer cannot inform himself about quality. As long as the high and the low qualified workers agree to work at this wage there is no problem, but the high qualified worker may not want to make this transaction because the average wage is too low, than adverse selection becomes a problem. 


What is the difference between “hostage” as a way to secure transactions and “collaterals”?

In what way can these “techniques to overcome contracting problems in a “state of nature” be affected by opportunistic behavior? (slides; Kronman 1985)

Hostage: provide something of value to hostage giver.

I am asking for something that YOU value, something YOU want back badly enough to fulfil your initial promise, if that is the only condition under which I will return the hostage to you. But I cannot be sure if this hostage is as important to you as you make me think it is.

Collateral: provide something of value to hostage taker .

I offer something that has a direct use or exchange value to ME. What matters to me is that I now have an asset which is a direct substitute for the performance you have promised, an asset whose value I can realize through use or trade and without having to deal with you at all. In contrast to a hostage, which gives me a power that can only be realized by means of threats. 






Please, explain why, under certain assumptions, it is worthwhile for the most able employees among a group of employees to invest into education? (slides; Varian 2005)

f a company decides to invest in education and if both (able and unable workers) may acquire more education, the costs will include not only attending school, but also includes the opportunity cost, the costs of the effort required, and so on. That means that the marginal cost of acquiring education is less for the able workers than the unable workers.

The able workers all acquire a educational level e and the unable workers all acquire educational level 0, and the firm pays workers with educational level e a wage of a2 and workers with less education than a wage of a1. The choice than of education level of a worker will signals if he is a able or an unable worker and that will be worthwhile for the company.


  • If each able worker choses education level e* and each unable worker choses education level 0 (equilibrium because no worker has a reason to change his behavior) the educational level of a worker can, in equilibrium, serve as a signal of the different productivities.
  • Each able worker, thus, finds it in his interest to pay for acquiring the signal, not because it makes them more productive, but because it distinguishes them from the unable workers.
  • If both workers would earn an average wage, then the wage of the able workers would be depressed because of the presence of unable workers. Thus they would have an incentive to invest in signals that distinguish them from less able workers. This investment offers a private benefit but no social benefit. 



Why and how does asymmetric information lead to market failure? (slides)

When we have asymmetric information, a contractual partner has more relevant information than the other, or lack of information can also lead to failures (inefficient allocation/no market). E.g: You are buying a piece of land and you want a good soil quality. You have many offers, but nobody can certify the soil quality, You will not pay more just because somebody said that have the best soil quality (predicting opportunistic behaviour), that means that you will be willing to pay the same price for bad and good quality soils (market failure!!) because you cannot have the full information about the land you are buying. 


Asymmetric information:

  • the agent enjoys some informational advantage over the principle.
  • can be categorised as ex ante, pre-contractual of the transaction, or ex post, post-contractual of the transaction.

Two types of asymmetric information exists:

  1. adverse selection (pre contractual asymmetric information)
  2. moral hazard (post contractual asymmetric information).

create market failures: 

  1. in product markets where low quality products drive out good quality products,
  2. insurance markets where low risk groups do take out insurance and high risk groups do 
  3. other markets where principals do not receiving productivity/ return from agents. 


Why do transaction partners have problems of contracting where the conditions of contracts according Arrow-Debreu are not fulfilled?

What does the Arrow-Debreu contract entail?

What are problems and what are their causes and for what types of transactions are contracting problems specifically significant, why? (slides; Furubotn et al. 2003 Ch.5)

Fully contingent contract (Arrow-Debreu):

  • explicitly agreed-upon symmetric information contracts (the problem is that it is not realistic, because we have often asymmetric information: e.g: we know better what you have than what you will receive) 
  • Binding in an ex-ante clearly defined sense (that means that everything is regulated on the contract and this is not realistic, because after the contract is sign, we may discover something new about what you receive e.g. The heating system of the haus you bought is not working efficient as it was described at the contract)
  • Independently if formal or informal agreements (not realistic, because a contract may also be an oral agreement)
  • Short term or long term, standard or complex (in reality, contracts tend to be more complex, because information may be hidden in this transaction and things that are not predicted may happen).
  • Individual/collective or agency does not matter (in reality it does matter, because there will be different objectives and interest involve in individuals, collectives and agency).
  • Third party enforced (by courts) (in reality there is other ways of enforcement such as self-enforcing mechanisms like reputation). 




Describe the problems of pre-contractual and post-contractual opportunism related to issues of asymmetric information.

Use one example for each case of opportunism. (slides)



Describe a moral hazard and adverse selection problems, specify who bears the problem and why. (slides; Furubotn et al. 2003 Ch.5; Varian 2006)

Adverse selection (ex ante) is that competition leads to selection of „bad“ qualities as good qualities no incentive to offer, bad and good qualities good will have the same price, meaning a market failure. 

For Example: There are new/ used cars. There are good / bad cars (which in America are known as "lemons"). A new car may be a good car or a lemon, and of course the same is true of used cars. The individuals in this market buy a new automobile without knowing whether the car they buy will be good or a lemon. But they do know that with probability q it is a good car and with probability (1-9) it is a lemon; by assumption, q is the proportion of good cars produced and (1-q) is the proportion of lemons. After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine; i.e., the owner assigns a new probability to the event that his car is a lemon. This estimate is more accurate than the original estimate. An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers. But good can and bad cars must still sell at the same price- since it is impossible for a buyer to tell the difference between a good car and a bad car (Akerlof 1970: The market for „lemons“). 


Moral hazard: one party can change transaction relevant factors ex post without knowledge of other party. The problem here is that expectation on opportunism is included in price because the asymmetry information.

For Example: farmers assign contracts of insurance with the land owner to assure that the lazy farmers will work and contribute to the harvest (because the land owner has problems to monitors if it was the weather or the lazy farmers the reason for bad harvest rates). To monitors all hard-work and lazy farmers will get the insurance and the hard-workers will end up paying high prices for the insurance because of the bad reputation of the lazy farmers.

In the two cases, who bears the problem will be the honest actors, that will end up paying higher prices for the bad reputation (the opportunistic behaviour) of others. 


What does Kronman describe as “state of nature”?

What are problems for the economic order that he describes? (slides; Kronman 1985)

In a world without the enforcing mechanism of the state, would market transactions take place? That is the meaning of state of nature. Which other mechanisms take place to “substitute” the role of the state. In a world without the state, someone could just “steal” your right about something e.g: your land.

In state of nature, where there is no state to protect contracts by law, there are and because of that are some problems such as:

  • Vulnerability of possession: Overcome through equal Threats
  • Transactional insecurity:
    • Simultaneous exchange not problematic,
    • Problems where deferred service provision
  • exchange barter for contract and make exchange simultaneous - where (often) impossible > no exchange
  • No money in state of nature, but only real value 

Agreements still possible? Techniques: Individuals have incentive to exchange:

  • Hostages, collateral, make agreements self-enforcing through „hands tying“, „union“ 

Incentive to make exchange simultaneous, in state of nature

  • e.g. eat fruit in each others‘ presence 


What are relative property rights? To which extent contracts depend on third party enforcement and how does this affect the “freedom” of contracts? (slides; Furubotn et al. 2003 Ch.4)

  • Relative property rights are the rights established between specific persons.
  • Relative property rights consist of a claim of a certain individual, the obligee, against one or more other individuals, the obligor(s), and can only be exercised against them.
  • Relative property rights can be violated or « stolen » (opportunistic behaviour) by the person(s) against whom claims are directed.

the freedom of contract enables the private owner of a property right to transfer his right, and the asset to which the right refers. It also includes the freedom to conclude a contract or not, to choose the partner to a contract, to determine the form and the content of the contract. But the contract just take place if a third part is involve to assure that the terms will be followed (the state as a third part) will do the necessary enforcements, predicting opportunistic behaviour. 

 ..... tbc....


Describe the hold-up problem.

How does the hold-up problem relate to asset specific investments?

A hold-up problem relates to a long term contractual relation where are hidden problems that you have the intention to renegotiate after concluding it (ex-post). For example a reap rent from specific investment (deception, betrayal). The specific investment (e.g. quality-level specifications, time of delivery, what quantity of units) cannot be determined with certainty beforehand. 

For example: The Buyer (aka GM) and the Supplier (aka Fisher Body): In a first stage, the Buyer makes a relationship- specific investment (i.e. decides to set up their line of production such that it depends on specific car body parts delivered by Fisher Body). Then (due to the unforeseen increased demand), the Supplier has the opportunity to raise the price (for the additional demand). In case the price is raised, the Buyer can, at their loss, change the Supplier.

Solutions: Contractual warranty, forward or backward integration 

Specific assets create the potential for hold-ups:

“Once a transactor makes a relationship­specific investment, its transacting partner has the ability to take advantage of the specificity to appropriate some of the rents the transactor expects to earn on the investment.” Specific assets are assets that have a significantly higher value within a particular transacting relationship than outside the relationship. Resources depend upon on another. Due to transaction-specific investments the investment creates dependency (lock-in/hold up effect) that can be used by the other party in his/her benefit.

Example: coffee pad machines leads to lock-in effect: machine buyer is bound to special pads from the coffee pad machine producer. Buyer is dependent from price setting of the producer. 


Why do for example “collaterals” or “hands-tying” also apply where a state exists?

Why the state is not fully effective in coping with contract ineffectiveness? (slides; Kronman 1985)

The existence of the State can only reduce but not avoid insecurity with temporally asymmetrical exchanges because:

1. State only guarantees for obvious damages/ losses
2. Costs of measurement and dispute resolution
3. State adds another layer of risk of opportunistic behaviour

For example: creditors often ask for some value as collateral to secure loans to have valuable property of creditor defaults. In some specific investments, to create reputation is an example of hands tying.
For instance creditors may ask for some value as a “collateral” to secure a given loan in the case the loanee defaults or isn’t actually credit­worthy (ex ante opportunistic behaviour ­ hidden characteristics). Moreover the adverse impacts or influences of insolvency of one transacting partner can be eliminated or at least reduced for the other party by the provision of an appropriate “collateral”. The provision of an asset specific investment by both contractual parties is an example of “hands tying”. Through the investment into a future transaction the agreement gets self-enforcing as both parties have great incentives to follow the agreement or the contract otherwise they would lose their investments.


The state isn’t fully effective in coping with contract ineffectiveness as it only guarantees for obvious damages/ losses, so there is always some risk of not being fully compensated for a certain loss which is considered too remote or speculative.
Secondly even if a loss falls within the limited domain of harms
which the law of contracts acknowledges to be compensated, it must still be measured. As the measurement is pursued by someone else than the claimant there is always some risk of underestimation of the actual value of the loss or damage. So there remains again a risk of undercompensation. So there may be costs of measurement and dispute resolution. Moreover the state adds another layer of opportunistic behavior. 


Please, give examples of principals and agents in different contexts, name the principal and the agent and identify one non-contractible aspect in those contexts. (slides)

  • Horse trader (agent) and the cattle breeder (principal)
  • Physician (agent) and patient (principal): Physician takes the actions that may affect the principal.
  • Owner of the property (principal) and the farmer (agent)
  • Policy makers (principal) and citizens (principal) 

Principal: cannot assure or does not have entirely control of the situation. 



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