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Ch 14 Agency

Ch 14 Agency. Principal-Agent Relationship. Principal owns an asset Agent works on principal’s behalf to preserve on enhance the value of the asset Problem - the agent’s interests can diverge from that of the principal. Example. Smith and Jones enter into an agreement to provide auto repairs

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Ch 14 Agency

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  1. Ch 14 Agency

  2. Principal-Agent Relationship • Principal owns an asset • Agent works on principal’s behalf to preserve on enhance the value of the asset • Problem - the agent’s interests can diverge from that of the principal

  3. Example • Smith and Jones enter into an agreement to provide auto repairs • Smith provides tools and a shop • Jones provides labor • Suppose the relationship is initially 50-50

  4. Example • Either could be the firm’s “owner” • Both the tools and the worker combine to fix an engine in a team effort • Smith and Jones need each other to produce auto repair

  5. Example • The individual contributions of each cannot be determined • Thus, an individual member could “shirk” • The resource owners in the team need to be monitored. • But, by whom? Who has the greater incentive to monitor

  6. Who is to be the monitor? • The party with the least incentive to shirk • The least mobile party

  7. Who is to be the monitor? • For efficiency- the party central to all contracts

  8. Example • In exchange for monitoring: this factor is the “residual claimant” • Thus, it must be able to commit to guarantee all other factors that they will be paid • Thus, capital has become known to be the “owner” of the firm

  9. Math Example • Suppose that there is no team production and that workers can be costlessly monitored • Workers utility function U = (I - e2) • Worker requires a minimum $1,000 just to show up for work

  10. Math Example • Workers utility function U = (I - e2) • Worker requires a minimum $1,000 just to show up for work • You must compensate me if you want me to exert more effort • Ex: If e =10, then I =$1,100 Ex: If e = 100, then I = $11,000

  11. Math Example • Thus, the cost to the firm is: • C = 1000 + e2

  12. Math example • Suppose the firm benefits by $100 for each extra unit of effort made by the employee • B = 100e

  13. The Firm’s Goal • Pick a level of effort that maximizes profit • Profit = 100e - (1000 + e2) • dProfit/de = 100 - 2e • Set equal to zero, yields e =50

  14. Profit Maximization • By paying the worker 1000 + 502 = $3,500 the firm offers the incentive to the worker to put forth 50 units of effort • The firm could elicit more effort from the worker, but the additional cost would exceed the additional benefit

  15. Profit Maximization • By paying the worker 3,500 • the firm gets 50 units of effort • This yield 5,000 in gross benefits to the firm • Less the 3,500 salary to the worker • yields a profit of 1,500

  16. Problem • If the salary is fixed at $3,500 and “e” is not costlessly observable

  17. Problem • If the salary is fixed at $3,500 and “e” is not costlessly observable • then worker has the incentive to shirk

  18. One Possible Solution • Let the worker buy the right to all of their output • Worker pays the firm 1,500 for the right to all of the gross benefits • Will the worker behave efficiently?

  19. Problem with Ownership • Wealth constraint - labor may not have the resources to become franchisee • Risk aversion - output is a function of more than just effort • Team production - benefits are an inseparable function of effort made by many different workers

  20. Piece Rate Contract • Pays a fee for each unit of output • This provides incentives for worker to work • possibly producing too much

  21. Second Best Contract • Compensation as a function of performance • W = a + BX • B increases with • ability of the agent to bear risk • lower effort costs by the agent • higher marginal contribution of effort • clear performance measure

  22. Math Example • Suppose “e” cannot be observed but gross revenue can be • Suppose gross revenue depends on worker’s effort plus other factors

  23. Revenue = f(e, X)

  24. Incentive Compatibility • Establish a salary structure so that workers • U(e =50) > U(e=40)

  25. Incentive Compatibility • Establish a salary structure so that workers • U(e =50) > U(e=40) • Ex: Let Y = salary when B = 5000 • and let Z = salary when B = 4000 • Then Incentive compatibility requires • 3/4(Y-2500) + 1/4(Z-2500) > 1/4(Y-1600) + 3/4(Z-1600)

  26. Incentive Compatibility • Incentive compatibility requires • 3/4(Y-2500) + 1/4(Z-2500) > 1/4(Y-1600) + 3/4(Z-1600) • Solving yields Y > Z + 1800

  27. What happens when the riskiness of those revenues falls?

  28. What happens when the riskiness of those revenues falls? • You reduce the premium paid for the higher productivity

  29. Other Shirking Deterrents • Bonding

  30. Other Shirking Deterrents • Bonding • Back-loading

  31. Other Shirking Deterrents • Bonding • Back-loading • Bonuses

  32. Other Shirking Deterrents • Bonding • Back-loading • Bonuses • Promotions

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