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1. PPS231S.01Law, Economics, and Organization

   Spring 2012 I.3. Incentives
2. Incentives Principals and Agents In this module, we truly begin our study of the interaction between law, economics, and the study of organizations. We study “incentives,” which is an awfully broad topic. Likewise, asking “Do incentives matter?” is asking abroad question – One to which we could answer: “Yes, we know that the Law of Demand (generally) holds.”
3. Incentives When economists discuss “incentive theory,” what they refer to most often is agency theory, or contract theory, i.e., the study of principal-agent relationships. What is a contract? The simplest answer is “Anything that is not a spot transaction.” But then, what is a spot transaction? It is a transaction that occurs spontaneously – buyer and seller meet on the market; buyer pays seller; seller gives up good or provides service to seller immediately.
4. Incentives Contracts involve a certain length of time, even though they are often modeled as static games with a sub-game perfect Nash equilibrium. Examples: Ordering a book from Amazon.com Renting an apartment Financing a real estate purchase with a mortgage Leasing out a plot of land to a tenant … There are thousands upon thousands of examples!
5. Incentives “All models are wrong, but some are useful.” – George Box. To study agency relationships, we strip down the contractual environment to its bare essentials. Typically, a contract involves two parties: (i) the principal; and (ii) the agent. And typically, the principal hires the agent to perform a certain task, in exchange for compensation.
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7. Incentives Two Essential Features of Agency Relationships 1. The agent’s effort and/or type is unobservable, or only partially observable at prohibitive cost. Example: Agricultural uncertainty in land tenancy; Riskiness of drivers in automobile insurance. 2. The incentives are not perfectly aligned between the principal and the agent. The principal would really like the agent to exert the highest effort possible, but the agent really only wants to do enough to get paid.
8. Incentives Recall this scene from “Office Space” (1999). Peter works for Initech, which has hired two consultants to downsize the company. The consultants interview each employee. http://movieclips.com/2pyJo-office-space-movie-motivation-problems/ What is the incentive problem (i.e., misaligned incentives) here? How does Bob offer to fix it? What’s the causal mechanism?
9. Incentives Thus, the study of incentive problems is only interesting when the two conditions above hold, i.e., agent effort is unobservable and the incentives of the principal and the agent are not aligned. Can you see why? What if agent effort is observable? What if the incentives of the principal and the agent are aligned?
10. Incentives Two Information Asymmetries There are two types of information asymmetries between the principal and the agent, and they are not mutually exclusive: 1. Agent effort is unobservable; and/or 2. Agent type is unobservable. (Note: Both problems mean that the First Fundamental Theorem of Welfare Economics no longer holds.)
11. Incentives Two Information Asymmetries 1. Moral Hazard Moral hazard occurs when the principal cannot observe the behavior of the agent ex post, i.e., after the contract is signed. Milgrom and Roberts (1992): moral hazard is “the form of post-contractual opportunism that arises because actions that have efficiency consequences are not freely observable and so the person taking them may choose to pursue his or her private interests at others’ expense.”
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13. Incentives Two Information Asymmetries In the neoclassical model of section I.1, moral hazard was not a problem. Consumers could perfectly observe the quality of the goods they purchased from firms, firms could perfectly observe the quality of the inputs they purchased from consumers, consumers who supplied their labor to firms did not shirk on the job, and the firms acted in the interest of their stockholders.
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15. Incentives Two Information Asymmetries 2. Adverse Selection Adverse selection occurs when the principal cannot observe the type of the agent ex ante, i.e., before the contract is signed. Thus, adverse selection is a form of pre-contractual opportunism. The presence of heterogeneous types (e.g., differences in quality, riskiness, etc.) on the market causes inefficiencies, and the First Fundamental Theorem of Welfare Economics no longer holds.
16. Incentives Two Information Asymmetries To understand adverse selection, let’s consider a simple yet classic example: Akerlof’s (1970) market for lemons. Two types of cars on the market: good cars (G) and bad cars (B) – bad cars are referred to often as “lemons”. Buyers’ WTP for a good car is PG and PB for a bad car, and of course PB < PG. Assume for simplicity that sellers’ WTA is symmetric. The proportion of good cars on the market is α, so that the proportion of bad cars on the market is 1 – α.
17. Incentives Two Information Asymmetries When presented with the opportunity to buy a car, a buyer’s WTP will simply be his expected WTP considering the quality uncertainty of the car she is presented with. That is, E(P) = αPG + (1 – α)PB Obviously, PB < E(P) < PG.
18. Incentives Two Information Asymmetries But then, since every buyer is only willing to pay E(P), no seller of a good car will be willing to sell at that price, and all sellers of bad cars will be willing to sell at that price, i.e., the market completely unravels and becomes a market for lemons. In reality, there often exists a continuum of types (or close to one), so that the market will not completely unravel. An example of complete market unraveling would be a voluntary market for automobile insurance. How so?
19. Incentives Two Information Asymmetries Here’s a personal example: The Universitéde Montréal’s student government’s vision and dental insurance plan during the 1997-1998 academic year. The student government asked students whether they would like the option to join a (voluntary) vision and dental insurance plan – 58 percent voted “Yes.” In January 1998, the insurance plan came into effect. A year later, the insurance company wanted to break the contract with the student government. Can you see why?
20. Incentives The Identification Problem of Contract Theory The following is a true story. In 1990, enumerators were sent to several of the busiest intersections in Washington, DC to gather data on the cars that run red lights, all on the same day, for the same length of time. → Of all the cars running reds, it turns out that Volvos were significantly overrepresented!
21. Incentives The Identification Problem of Contract Theory The $64,000 Question: Is this an example of adverse selection or moral hazard?
22. Incentives The Identification Problem of Contract Theory The $64,000 Question: Is this an example of adverse selection or moral hazard? We don’t know!
23. Incentives The Identification Problem of Contract Theory Volvos have a reputation for being the safest cars money can buy. So either Very bad drivers choose to buy Volvos as a form of partial insurance or commitment device → Adverse selection Otherwise indistinguishable drivers who buy Volvos feel “too safe” in them and are less careful → Moral hazard.
24. Incentives The Identification Problem of Contract Theory The key point is that without anything more (e.g., random assignment of drivers to cars), it is impossible to determine which of the two information asymmetries causes a departure from efficiency. The term “identification problem” comes from the statistical/econometrics literature: it is impossible to identify the causeof the inefficiency.
25. Incentives Prendergast (1999) The title of the paper is “The Provision of Incentives in Firms,” but Prendergast’ssurvey concerns more than just firms. Examples: Piece rates, options, discretionary bonuses, promotions, profit-sharing, efficiency wages, deferred compensation, etc. Two things: (i) underlying assumption that agents respond to incentives; and (ii) do firms write contracts with that in mind?, i.e., do contracts correspond to theoretical predictions.
26. Incentives Prendergast (1999) Note that these two questions correspond to the two major lines of inquiry in applied contract theory: 1. Do incentives matter? 2. Do we observe in the data the contracts that the theory says we should be observing?
27. Incentives Prendergast (1999) Main theme in the literature: contracts trade off risk sharing and incentives (we will be discussing this at length in a few weeks.) Incentives = Pay-for-performance Risk = Depends on context
28. Incentives Prendergast (1999) The upper bound on pay-for-performance in any contract is the amount of risk borne by the agent. Conversely, the constraint on the amount of insurance (the inverse of the amount of risk borne by the agent) provided in any contract is its incentive nature.
29. Incentives Prendergast (1999) 1. Do incentives matter? By and large, they do. Agents respond to incentives. A more interesting question is whether incentive power increases as the performance measure becomes less noisy. Here, the evidence is not as clear cut.
30. Incentives Prendergast (1999) Lazear (1996) on wages vs. piece rates and autoworkers installing windshields (productivity increased by 35 percent, one-third attributed to selection). Paarsch and Shearer (1996) on Canadian tree planters. Climatic and soil conditions determine either piece rate or salary. Raw productivity difference is again 35 percent; more than two-thirds attributed to selection). Also: British jockeys; weight reduction of agricultural workers in the Philippines; etc.
31. Incentives Prendergast (1999) 2. Do contracts reflect agency concerns? This is a much harder question. The bulk of this literature has used CEO compensation data, which we will look at explicitly this semester. In this case, the dependent variable is contract choice (e.g., wage; piece rate; mixture of both.)
32. Incentives Prendergast (1999) In that case, there is some evidence that contracts are signed to trade off risk-sharing and incentives, but it’s not completely convincing. One of the main problems is that risk aversion, while a simple concept, is extremely difficult to measure, and most proxies are useless (Bellemare and Brown, 2010).
33. Incentives Prendergast (1999) Miscellaneous Points: 1. Multitasking 2. Tournament theory (e.g., Millennium Challenge Corporation) 3. Efficiency Wages (Shapiro and Stiglitz, 1984) 4. Deferred compensation and relational contracts (example of baseball player on a wage, but with contract renewal pending.)
34. Summary What are the key points from this section? What’s a contract? Examples Two essential features: effort observability, alignment of incentives Moral hazard and adverse selection Identification problem of contract theory Prendergast on the strands of research in applied contracts: incentives and predicted contracts Prendergast on the empirical evidence