Lecture 4 - Agency Theory Flashcards
Agency Theory
Behavioral assumptions
- Complete rationality
- Opportunistic behavior
Agency Theory
Contracts
Complete contracts
* All observable information is contained in the contract
* All observable information is also verifiable
Assumptions about the Principle & Agent
- Principle
o Uninformed
o Risk-neutral
o Profit depends on agent’s effort
o All bargaining power (there are many As but one P) - Agent
o Informed and imperfectly observed
o Risk-averse
o Disutility of effort and choose level of effort
o Has an opportunity cost
Focus of Agency Theory
- Problems
o Uncertainty
o Asymmetric information
o Risk-averse agent - Solutions
o Incentives
o Monitoring
o Job design
Ingredients in the Principle-Agent Problem
- An available surplus
- From interacting
- A conflict of interests
- Effort of agent
- Risk on agent
- Asymmetric information
- Agent has superior information
- (Uncertainty)
Why agency problems arise
- Differences in information
- Conflict of interest
Types of agency problems
- Moral Hazard / Hidden Action Problem
- Information asymmetry (effort and nature) is used by the agent in determining his decision because P cannot directly observe if a bad result is due to nature or A’s action
- Hidden Characteristics Problem / Adverse Selection
- Decision of A is observable
- Characteristics of A (capabilities, aversion to effort, risk-aversion) is hidden
- As will respond differently to the same contract
Moral Hazard
- The agent can engage in post-contractual behavior that affects the utility of both P & A
(externality) - P can only observe an imperfect signal of A’s effort – outcome, not effort
(control problem) - The action A takes spontaneously is not optimal
(inefficient) - Fix: Aligning interests:
o Moral hazard can be reduced by incentivizing the agent
(assigning income rights)
3 strategies for handling the agency problem
- Change the choice possibilities
o Job decryptions, tasks, what can be done with firm resources - Engage in monitoring
o Change the information - Provide incentives
o Change payoffs
How to maximize value in an principal-agent relationship
Choosing a combination of α & β
* Incentive intensity: the size of β
* Monitoring intensity: the amount of resources needed to estimate e
Advantages and disadvantages of a high beta
- Advantages
o Fine when effort has a high incentive elasticity
o Self-selection: laggards & shirkers stay away
o Can foster upgrading of skills & knowledge - Disadvantages
o Heterogeneity in the measure
o Multi-tasking problem, e.g., reduction of helpfulness
o Difficult to decide the “normal” effort level (i.e., when beta=0)
Monitoring intensity
- Higher monitoring –> reduces the variance Var(x) on the estimate of agent’s effort –> reduced risk on agent –> reduced risk-premium –> increased total value
- Optimum: marginal benefit of monitoring = marginal cost of monitoring
Participation constraint
The agent must earn his opportunity cost for all levels of effort.
The principal considers this when choosing α & β
Incentive Compatibility Constraint
P will structure the contract such that A will choose the behavior/effort P desires
Risk-premium depends on
- Degree of risk-aversion
- Degree of uncertainty
