Economics 202: Intermediate Microeconomic Theory

1. Economics 202: Intermediate Microeconomic Theory • Welcome back

2. Asymmetric Information • Transactions can involve a considerable amount of uncertainty • can lead to inefficiency when one side has better information • The side with better information is said to have private information or asymmetric information

3. The Value of Contracts • Contractual provisions can be added in order to circumvent some of the inefficiencies associated with asymmetric information • rarely do they eliminate them

4. Principal-Agent Model • The party who proposes the contract is called the principal • The party who decides whether or not to accept the contract and then performs under the terms of the contract is the agent • typically the party with asymmetric information

5. Leading Models • Two models of asymmetric information • the agent’s actions affect the principal, but the principal does not observe the actions directly • called a hidden-action model or a moral hazard model • the agent has private information before signing the contract (his type) • called a hidden-type model or an adverse selection model

6. First, Second, and Third Best • In a full-information environment, the principal could propose a contract that maximizes joint surplus • could capture all of the surplus for himself, leaving the agent just enough to make him indifferent between agreeing to the contract or not • This is called a first-best contract

7. First, Second, and Third Best • The contract that maximizes the principal’s surplus subject to the constraint that he is less well informed than the agent is called a second-best contract • Adding further constraints leads to the third best, fourth best, etc.

8. Hidden Actions • The principal would like the agent to take an action that maximizes their joint surplus • But, the agent’s actions may be unobservable to the principal • the agent will prefer to shirk • Contracts can mitigate shirking by tying compensation to observable outcomes

9. Hidden Actions • Often, the principal is more concerned with outcomes than actions anyway • may as well condition the contract on outcomes • Agent cannot completely control the outcome! • tying the agent’s compensation to outcomes exposes the agent to risk • if the agent is risk averse, he may require the payment of a risk premium before he will accept the contract

10. Owner-Manager Relationship • Suppose a firm has one representative owner and one manager • the owner offers a contract to the manager • the manager decides whether to accept the contract and what action e 0 to take • an increase in e increases the firm’s gross profit but is personally costly to the manager

11. Economic Model • The firm’s gross profit is g = e +  • where  represents demand, cost, and other economic factors outside of the agent’s control • assume  ~ (0,2) • c(e) is the manager’s personal disutility from effort • assume c’(e) > 0 and c’’(e) > 0

12. Owner-Manager Relationship • If s is the manager’s salary, the firm’s net profit is n = g– s • The risk-neutral owner wishes to maximize the expected value of profit E(n) = E(e +  –s) = e – E(s)

13. Owner-Manager Relationship • We will assume the manager is risk averse with a constant risk aversion parameter of A > 0 • The manager’s expected utility will be

14. First-Best • With full information, it is relatively easy to design an optimal salary contract • the owner can pay the manager a salary if he exerts a first-best level of effort and nothing otherwise • for the manager to accept the contract (participation constraint) • E(u) = s* - 0 - c(e*)  0 • Zero is the value of the next-best job offer, for simplicity

15. First-Best • The owner will pay the lowest salary possible [s* = c(e*)] • The owner’s net profit will be E(n) = e* - E(s*) = e* - c(e*) • FOC ? 1 - c’(e*) = 0 or equivalently, 1 = c’(e*) • at the optimum, the marginal benefit equals the marginal cost of effort

16. Second Best • If the owner cannot observe effort, the contract cannot be conditioned on e • the owner may still induce effort if some of the manager’s salary depends on gross profit • suppose the owner offers a salary such as s(g) = a + bg • a is the fixed salary and b is the power of the incentive scheme

17. Second Best • This relationship can be viewed as a three-stage game • owner sets the salary (choosing a and b) • the manager decides whether or not to accept the contract • the manager decides how much effort to put forth (conditional on accepting the contract) • Use backward induction

18. Second Best • Because the owner cannot observe e directly and the manager is risk-averse, the second-best effort will be less than the first-best effort • the risk premium adds to the owner’s cost of inducing effort • Stage 3’s (how much effort to give) first-order condition?

19. Second Best • Result: Manager’s effort responds to increased incentives • Graph of c’(e) vs. e • Stage 2: Participation constraint

20. Second Best • Stage 1: Owner chooses a and b • Owner maximizes her expected surplus, subject to the participation constraint and the incentive compatibility constraint • Participation • Incentive compatibility constraint • Manager chooses e to suit himself rather than the owner, who can’t observe e • Rewrite surplus as

21. Second Best • What is optimal e**? Optimal second-best effort. • Second-best effort < 1 and so less than first-best effort e*=1. Asymmetric information leads to lower equilibrium effort. • Second-best contract trades off incentive vs. insurance: the owner’s desire to induce high effort (b near 1) against need to insure risk-averse manager against salary variation (b near 0).

22. First- versus Second-Best Effort The owner’s MC is higher in the second best, leading to lower effort by the manager MC in second best c’(e) + risk term MC in first best c’(e) MB 1 e e** e*

23. Moral Hazard in Insurance • If a person is fully insured, he will have a reduced incentive to undertake precautions • may increase the likelihood of a loss occurring • The effect of insurance coverage on an individual’s precautions, which may change the likelihood or size of losses, is known as moral hazard

24. Is Education a Good Social Investment? • Empirical studies seem to indicate education is a good individual investment • Is education primarily a signaling device in the labor market? • What if the informed player moves first? Unlike the uninformed principal, we were just discussing, who made an offer to the agent who had private info.

25. Is Education a Good Social Investment? • Example: If you have BA, you can earn $1,600,000 (over lifetime in PV). If not, you get $800,000. Clow-prod = 225,000(E-12) Chigh-prod = 50,000(E-12) Low-prod worker: (16-9) < (8-0)  no college High-prod worker: go to college For a BA to be effective signal, cost of acquiring signal must be strongly & inversely related to worker’s job productivity (psychic costs/innate ability) • If education doesn’t improve one’s skills, but only helps firms identify those with the highest innate ability, higher education may be socially unnecessary! Clow-prod PV ($100K) 16 12 8 Chigh-prod 4 0 16 20 Education (years) 12