Moral Hazard: Redistribution and Moral Hazard

In chapter 3, we have already seen how the conflict between incentive compat­ibility and budget balance leads to the under-provision of output in an adverse selection model. The same qualitative result still holds in a moral hazard environ­ment. Expected volume of trade may be reduced by moral hazard. To illustrate this point, we consider

Nonverifiability in agency theory

When two parties engage in a relationship, it is often the case that they are uncer- tain about the value of some parameter that will affect their future gains from trade. This uncertainty is represented by assuming that the parameter can take several values, each value corresponding to different states of nature whose prob-

Nonverifiability: No Contract at Date 0 and Ex Post Bargaining

With the same model as in chapter 2, we now assume that the parameter θ is unknown at the contracting date (date t = 0) but becomes common knowledge between the two parties, the principal and the agent, later on (at date t = 1). First we examine the case where no initial contract

Nonverifiability: Incentive Compatible Contract

Instead of waiting for the realization of the state of nature, the principal can offer to the agent, at the ex ante stage (date t = 0), a contract that ensures ex post efficiency under some rather weak conditions, as we see in the following. This contract can only be written in terms of

Nonverifiability: Nash Implementation

In section 6.2, we have just seen how the principal and the agent can achieve ex post efficiency through an ex ante contract when they are both risk neutral. This contract uses only the agent’s message but fails to achieve efficiency when the agent is risk-averse or when nonresponsiveness occurs. We now propose a

Nonverifiability: Subgame-Perfect Implementation

From proposition 6.4, a necessary condition for unique Nash implementation is that an allocation rule a(·) be monotonic. Any allocation rule that fails to be monotonic will also fail to guarantee unique Nash implementation. Then, one may wonder if refinements of the Nash equilibrium concept can still be used to ensure unique implementation. The

Nonverifiability: Risk Aversion

The previous sections have discussed how various sorts of mechanisms may help to implement the first-best allocation rule when both the principal and the agent are risk neutral. The objective of this section is to discuss the potential of those mechanisms when either the principal or the agent is risk averse. 1. Risk-Averse Agent 

Mixed Models of agency theory

The pure models of chapter 2 for adverse selection, chapter 4 for moral hazard and chapter 6 for nonverifiability were highly stylized contracting settings. Each of those models aimed at capturing a single dimension of the incentive problems that may be faced by a principal at the time of designing the contract for his

Mixed Models: Adverse Selection Followed by Moral Hazard

In the standard moral hazard framework of chapter 4, it was first assumed that the agent had no private information of his own. In insurance markets, insurees often have some prior information about how risky they are before exerting any effort to prevent this risk. Similarly, in credit markets, a borrower may know the

Mixed Models: Moral Hazard Followed by Adverse Selection

Sometimes an agent undertakes an initial nonverifiable investment or performs an effort before producing any output for the principal. For instance, the agent can choose a costly technology that affects the distribution of his marginal cost of production. At the time of choosing whether to incur the nonverifiable investment or not, the agent is

Mixed Models: Moral Hazard Followed by Nonverifiability

The last stage of our travel in the world of mixed models brings us to the analysis of models with both moral hazard and nonverifiability. We now assume that the agent first exerts a nonobservable effort that affects the realization of the state of nature, but this state of nature remains nonverifiable, even though

Dynamics under Full Commitment in Agency Theory

Contracts are often repeated over time. Examples of such long-term relationships abound and span all areas of contract theory. Let us describe a few. The insurance contract of an agent entails bonuses and maluses that link his current coverage and risk premium to his past history of accidents. Labor contracts often continue to reward

Dynamics under Full Commitment: Repeated Adverse Selection

Consider the twice repetition of the model in chapter 2, where we can make various assumptions on the information structure and, in particular, on how it evolves over time. The goal of this section is to compare the optimal long-term contract with its static counterpart. 1.  Perfect Correlation of Types and Risk Neutrality  Let

Dynamics under Full Commitment: Repeated Moral Hazard

Let us now move to repeated moral hazard relationship. The main goal of this section is to show how the past history of performances may help the princi- pal to relax incentive compatibility constraints, even when there is no correlation between shocks in different periods. 1. The Model  We will come back to the

Dynamics under Full Commitment – Constraints on Transfers: The Role of Implicit Incentives

In section 4.7, we reported the Fama (1980) argument according to which the labor market acts as an incentive instrument and provides managers with incentives to exert optimal effort levels. Indeed, managers want to influence the perception that the market has on their productivity. According to this argument, this desire for good reputation should

Agency theory: Informed Principal

In the basic framework of chapter 2, we have assumed that the uninformed party has all the bargaining power and makes a contractual offer to the privately informed agent. In the case of common value, i.e., where the principal’s utility function depends on the state of nature (V  = S(q, θ) − t), let us

Agency theory: Limits to Enforcement

In this volume, we have assumed that the judicial system is perfect and benevo- lent, and consequently can enforce any contract without cost. Implicit behind this enforcement is the use of penalties that prevent both partners from breaching the contract. We now briefly discuss a model of imperfect contractual enforcement. Consider the model in

Agency theory: Dynamics and Limited Commitment

In an intertemporal framework, what is needed for the optimal dynamic contract to be credible is not only the ability of the contractual partners to commit to a contract, but the stronger assumption that those two contractual partners also have the ability to commit not to renegotiate their initial agreement. The assumption that economic agents

Agency theory: The Hold-Up Problem

Let us now consider a setting where the agent has to make some initial investment before dealing with the principal. The motivation for this contractual setting is that the agent and the principal can only meet each other after the agent’s investment has been made. Such situations are likely to occur in market environments

Agency theory: Limits to the Complexity of Contracts

In most of this book, we have deliberately chosen to emphasize simple models, where shocks are discretely distributed both in the case of adverse selection and moral hazard. However, the analysis in appendices 3.1 and 4.2 also suggests that optimal contracts may have very complex shapes in the richer case where those shocks are