Week 9 term 1 Flashcards
(15 cards)
What is the central focus when analyzing the behavior of firms?
Incentives
The employer must delegate tasks to employees, which involves a Principal-Agent relationship.
Who are the two parties involved in the delegation of a task?
Principal and Agent
The Principal delegates the task, while the Agent is the one to whom the task is delegated.
What are the two basic ingredients of incentive theory?
- Conflicting objectives
- Decentralised information
What is the Principal-Agent problem?
Delegating a task to an agent with private information
Agent’s actions are not observed by the Principal, leading to moral hazard.
What does moral hazard refer to?
A situation where one party hires another to work on a project, but the effort exerted by the agent is unobservable.
Why is it difficult to write externally enforced contracts specifying compensation based on effort?
Agent’s effort is not verifiable/observable.
What are examples of moral hazard?
- Owner-manager relationship
- Insurance companies and insured individuals
- Manufacturers and their distributors
- Teamwork
- Banks and their borrowers
In the context of moral hazard, what does it mean for an employer to worry about an employee’s effort?
The employer cannot observe effort but can observe output.
What is the participation constraint (PC) in the context of contract design?
The contract must ensure Bob’s expected payoff is non-negative.
What is the incentive compatibility constraint (IC)?
The contract must ensure Bob has no incentive to exert low effort.
What does profit maximization for Ann require?
Both the participation constraint and incentive compatibility constraint must be satisfied with equality.
What happens if the participation constraint does not hold with equality?
Ann can reduce both xs and xf and still make Bob participate.
How can Ann increase her payoff regarding the incentive compatibility constraint?
By reducing √xf while keeping it the same, she can still satisfy the constraint.
What does Ann aim to do with her payoff?
Ann aims to reduce √x_s while still satisfying the constraint and increasing her payoff.
This relates to profit maximization in economic models.
Under profit maximization, how should the constraints be satisfied?
The constraints should always be satisfied as an equality.
This is a key principle in optimization problems.
