Agency

Question 1

What is the agency problem?

Answer 1

Where managers can act in their own self interest, this interest is unlikely to be in the public interest.

If there is asymmetric info the owners can’t observe these management decisions

Question 2

What is the agents utility function and how does it translate into a reservation wage?

Answer 2

• Agents utility is given by U(a,y) = v(y) - a
• The agents has a reservation utility I⁰ where they are indifferent between working or not
• This reservation utility has a corresponding wage which can be found in I⁰ = v⁰ = v(y) - a
• If the wage is below this value of y, the agent will not work

Question 3

What is the profit function for an owner of a company in a basic agency probelm and how do they maximise it?

Answer 3

• π = p(a) - y(a)
• ^dπ/_da = p’(a*) - y’(a*)
• Slopes of revenue and utility curve are the same

Question 4

How does an owner create a contract in a one state model with perfect info?

Answer 4

• they can observe either p(a) or a
• Owner can employ on a contract where y*=y(a*) conditional on p*=p(a*)
• If there is any other outcome then pay ý which is below y⁰⁰
• y⁰⁰ is the reservation wage for minimal effort so A would not want to work at all
• Contract: [(a*, y*), (ã, ÿ)]
• v⁰ > v(ÿ) - ã

Question 5

Explain how two exogenous states can create a hidden action problem

Answer 5

• Two different states of the world x₁ and x₂
• the levels of revenue are different for the two x₁(a) > x₂(a)
• Prob of x₁ = π
• for full effort x₂(a*), there will be a corrresponding x₁(a₀)
• Owner can’t tell whether the manager has been lucky and put in less effort or unlucky and put in full effort

Question 6

How does the owner create a contract for the manager to ensure a* in an exogenous two state model?

Answer 6

• If a = a⁰ there probability of being ‘lucky’ is π
• The probability of having obviously slacked off, where x₂(a⁰) < x₂(a*) is (1-π)
• in the contract offer y* if x >= x (tilda)
• Probability of being offered ÿ < y* is (1-π)
• Owner imposes large enough penalty so manager is never tempted to set a < a*
• ÿ must satisfy: πv(y*) + (1-π)v(ÿ) - a⁰ < v⁰

Question 7

Explain the expected profit levels for the agency model with endogenous states.

Answer 7

x₁ > x₂, a_H > a_L, π_H > π_L

Question 8

What are the reservation utility contraints for the endogenous model?

Answer 8

Expected utility from incomes - effort > v⁰

Question 9

What levels of income should the owners give the agent in the full information endogenous model?

Answer 9

Question 10

What is the incentive compatibility constraint in the private info endogenous model?

Answer 10

To encourage high level of effort the expected utility of high effort should be above that of the low effort.

Question 11

Show that there should be two different levels of income for the endoegnous model with private information

Answer 11