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

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

Agency theory: Limits in the Action Space

Let us now come back to an adverse selection context. Our goal in this section is to understand how one can possibly endogenize the action space used to contract with the agent. 1. Extending the Action Space We start with a highly stylized model of procurement between a principal (the buyer) and an agent

Agency theory: Limits to Rational Behavior

Even though incentive theory has been developed under the standard assumption that all players are rational, it can take into account whatever bounded rationality assumption one may wish to choose.38 However, there is an infinity of possible theories of bounded rationality and, in each case, the modeller must derive spe- cific optimal contracts. Let

Agency theory: Endogenous Information Structures

One often heard criticism of incentive theory is that it takes information structures as given. A more complete view of organizational design should account for the endogeneity of these information structures. To investigate these new issues, we now assume that the agent does not know his type a priori but can decide or not

Structural Determinants of the Intensity of Competition

Let us adopt the working definition of an industry as the group of firms producing products that are close substitutes for each other. In practice there is often a great deal of controversy over the appro• priate definition, centering around how close substitutability needs to be in terms of product, process, or geographic market

Intensity of Competition: Threat of entry

New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resources. Prices can be bid down or incumbents’ costs inflated as a result, reducing profitabili-ty. Companies diversifying through acquisition into the industry from other markets often use their resources to cause a shake-up, as Philip Morris did

Intensity of rivalry among existing competitors

Rivalry among existing competitors takes the familiar form of jockeying for position–using tactics like price competition, adver-tising battles, product introductions, and increased customer service or warranties. Rivalry occurs because one or more competitors either feels the pressure or sees the opportunity to improve position. In most industries, competitive moves by one firm have noticeable

Intensity of Competition: Pressure from substitute products

All firms in an industry are competing, in a broad sense, with industries producing substitute products. Substitutes limit the poten-tial returns of an industry by placing a ceiling on the prices firms in the industry can profitably charge. The more attractive the price- performance alternative offered by substitutes, the firmer the lid on industry

Intensity of Competition: Bargaining power of buyers

Buyers compete with the industry by forcing down prices, bar-gaining for higher quality or more services, and playing competitors against each other—all at the expense of industry profitability. The power of each of the industry’s important buyer groups depends on a number of characteristics of its market situation and on the rel-ative importance of

Intensity of Competition: Bargaining power of suppliers

Suppliers can exert bargaining power over participants in an in-dustry by threatening to raise prices or reduce the quality of pur-chased goods and services. Powerful suppliers can thereby squeeze profitability out of an industry unable to recover cost increases in its own prices. By raising their prices, for example, chemical companies have contributed to