1. Introduction. Klaus M. Schmidt. LMU Munich. Contract Theory, Summer 2010

Transcription

1 1. Introduction Klaus M. Schmidt LMU Munich Contract Theory, Summer 2010 Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

2 What is Contract Theory? What is Contract Theory? The basic problem: A group of individuals can generate some surplus if they cooperate and if everybody chooses the appropriate actions. Some individuals have an incentive to deviate from this behavior at the expense of the other members of the group. How to design an incentive system (a contract) that induces everybody to behave properly? Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

3 What is Contract Theory? If there are no informational asymmetries between the members of the group and between the group and the courts, then the solution to this problem is trivial: Write a complete contingent contract that governs the behavior of each agent in every possible state of the world. Nobody will deviate from this behavior because the courts will punish any deviation. The problem becomes more interesting when there are asymmetries of information and no complete contingent contracts can be written. In this case it is often impossible to implement the efficient allocation. What is the second best optimal contract (mechanism, organizational structure, etc.) that deals as well as possible with the informational asymmetries? Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

4 What is Contract Theory? Applications of contract theory: Incentive schemes for managers, workers, civil servants Regulation Price discrimination Taxation Financial contracts, capital structure Auctions Allocation of ownership rights (vertical integration, outsourcing, privatization) Political economy (design of political institutions) Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

5 What is Contract Theory? Contract Theory is now the most commonly used expression for this field of research, but it is also referred to as Principal-Agent Theory Implementation Theory Mechanism Design Theory of Incentives Transaction Cost Economics New Institutional Economics Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

6 Incentives in Economic Theory Incentives in Economic Theory Even though the importance of incentives was occasionally recognized in verbal statements and by practitioners, they played hardly any role in economic theory until the 1960s. Two reasons: Focus on large economies with competitive markets (partial equilibrium theory, general equilibrium theory): Welfare Theorems, markets provide efficient incentives even if people have private information. No tools to analyze strategic behavior and asymmetric information: Incentive provision could not be modeled. Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

7 Incentives in Economic Theory First steps: von Neumann and Morgenstern (1944): game theory, decisions under uncertainty Harsanyi ( ): games with asymmetric information Arrow (1963), Pauly (1968): moral hazard in markets Akerlof (1970, lemons market), Spence (1974, signaling), Rothschild and Stiglitz (1976, screening): adverse selection in markets Gibbard (1973): incentives in voting (social choice) Groves (1973): incentives to provide a public good (mechanism design) Vickrey (1961), Wilson (1967): incentives in auctions Vickrey (1945), Mirrlees (1971): redistribution and incentives Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

8 Incentives in Economic Theory Differences to Game Theory: Game Theory takes the strategic environment as given and asks: What is the optimal (and equilibrium) behavior of players in this environment. Contract theory designs the strategic environment so as to induce players to behave in the desired way. The question is: How can we change the strategic environment (by imposing a contract or an organizational structure) such that the resulting equilibrium behavior of the involved players is efficient. Thus, contract theory uses many tools of game theory, but the perspective is different. Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

9 Incentives in Economic Theory Differences to Information Economics: Information economics deals with information asymmetries in (competitive) markets. The types of contracts that can be traded are exogenously given. Question: What is the equilibrium allocation in a competitive market with asymmetric information? Contract Theory deals with information asymmetries in small groups and optimal contracts are derived endogenously. The market is left in the background. Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

10 Classification of Contractual Problems Classification of Contractual Problems 1. Moral Hazard: Symmetric information at the stage of contracting. Asymmetry of information arises during the relationship. Hidden action: The agent takes an action that cannot be observed by the principal. Principal observes only a noisy signal of the action. Hidden information: The agent privately observes the realization of the state of the world (after the contract has been signed). Principal observes the agent s action, but does not know whether the action is appropriate. 2. Adverse Selection: Asymmetric information before the parties negotiate the contract. 3. Non-Verifiability: The involved parties are symmetrically informed and observe the state of the world, but they cannot verify it to the courts. Therefore contracts are incomplete. Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

11 Classification of Contractual Problems Note: Some authors use a different classification. For example, Laffont and Martimort identify moral hazard with hidden action and deal with hidden information under adverse selection. Always ask yourself what the information structure under consideration is! Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12

12 Outline Outline of the course: 1. Introduction 2. Static Moral Hazard 3. Dynamic Moral Hazard 4. Adverse Selection 5. Relational Contracts and Career Concerns 6. Incomplete Contracts 7. Advanced Topics for Student Presentation Klaus M. Schmidt (LMU Munich) 1. Introduction Contract Theory, Summer / 12