In the Name of God

Sharif University of Technology

Graduate School of Management and Economics

Microeconomics 2
44706 (1394-95 2nd term) - Group 2

Dr. S. Farshad Fatemi

Chapter 14:

The Principal – Agent Problem

 The principal – agent model studies how the contracts will emerge when
the risk is involved. Then players’ attributes about risk is important.

There are two cases to be recognised

information is symmetric information is asymmetric

When information is symmetric finding the optimal contact is

straightforward.

The more interesting case is when information is asymmetric.

Microeconomics 2 Dr. F. Fatemi Page 188

Graduate School of Management and Economics – Sharif University of Technology
• Elements of the Basic Principal Agent model

The principal and the agent

The principal is the only responsible for designing the contract.

She offers a take it or leave it offer to the agent. No renegotiation.

One shot relationship, no repeated!

Microeconomics 2 Dr. F. Fatemi Page 189

Graduate School of Management and Economics – Sharif University of Technology
 Reservation utility = utility that the agent obtains if he does not sign the
contract. Given by other opportunities …

The relation terminates if the agent does not accept the contract

The final outcome of the relationship will depend on the effort exerted
by the Agent plus NOISE (random element)

So, due to NOISE, nobody will be sure of the outcome of the relationship
even if everyone knows that a given effort was exerted.

Microeconomics 2 Dr. F. Fatemi Page 190

Graduate School of Management and Economics – Sharif University of Technology
 Examples:

Principal: shop owner ; Agent: shop assistant

Sales will depend on the effort exerted by the shop assistant and on
other random elements that are outside his control (weather…)

Shareholders and managers

Patient and doctor

Lawyer and its clients

Microeconomics 2 Dr. F. Fatemi Page 191

Graduate School of Management and Economics – Sharif University of Technology
• Optimal contract under Symmetric Information

Symmetric Information means that effort is verifiable, so the contract

can depend directly on the effort exerted.

In particular, the P will ask the A to exert the optimal level of effort for
the P (taking into account that she has to compensate the A for exerting
level of effort)

Microeconomics 2 Dr. F. Fatemi Page 192

Graduate School of Management and Economics – Sharif University of Technology
 The optimal contract will be something like:

If effort = eopt then principal (P) pays WAGE (which should be more than
or equal agent’s reservation utility) to agent (A)

If not, then A will pay a lot of money to P

In this way the P will be sure that A exerts the effort that she wants

Note: in this case effort should be both observable and verifiable

Microeconomics 2 Dr. F. Fatemi Page 193

Graduate School of Management and Economics – Sharif University of Technology
• Moral hazard

The solution given to a problem that exhibits information asymmetry

will depend on the type of information asymmetry that is creating the
problem

In the standard moral hazard model, Information is symmetric before

the contract is accepted but asymmetric afterwards

Microeconomics 2 Dr. F. Fatemi Page 194

Graduate School of Management and Economics – Sharif University of Technology
 Two cases of moral hazard:

The agent will carry out a non verifiable action after signing the contract
(hidden action)
e.g. Salesman effort / Effort to drive alert / Effort to diagnose an illness

The agent knows the same as the principal before the contract is signed,
but it will know more than the principal about an important variable once
the contract is accepted (ex post hidden information)
e.g. whether or not the manager’s strategy is the most appropriate for
the market conditions

Microeconomics 2 Dr. F. Fatemi Page 195

Graduate School of Management and Economics – Sharif University of Technology
 Moral Hazard means that the action (effort) that the A supplies after the
signature of the contract is not verifiable.

This means that the optimal contract cannot be contingent on the effort
that the A will exert.

Consequently, the optimal contracts will NOT have the form that they
used to have when there is Symmetric Information.

Say that a Dummy Risk Neutral Principal offers to a Risk Averse Agent
the same contract under moral hazard that he would have offered him if
Information is Symmetric
Microeconomics 2 Dr. F. Fatemi Page 196
Graduate School of Management and Economics – Sharif University of Technology
 Threat is not credible because effort is no verifiable

... plus Wage does not change with outcome: no incentives.

RESULT: Agent will exert the lowest possible effort instead of the given
level of effort.

Clearly, if the Principal wants that the Agent will exert a given level of
effort, she will have to give some incentives

Microeconomics 2 Dr. F. Fatemi Page 197

Graduate School of Management and Economics – Sharif University of Technology
 The remuneration schedule will have to change according to outcomes

This implies that the Agent will have to bear some risk (because the
outcome does not only depend on effort but also on luck)

So, the Agent will have to bear some risk even if the Agent is risk averse
and the Principal is risk neutral

In case of Moral Hazard, there will not be an efficient allocation of risk

Microeconomics 2 Dr. F. Fatemi Page 198

Graduate School of Management and Economics – Sharif University of Technology
• The Model

A principal (P) and an agent (A);

A’s action is not observable

Is there a contract which P offers and indirectly gives A the incentive to

choose the action P prefers?

𝑒 ∈ 𝐸 ⊂ ℝ𝑀 is A’s hidden action

𝜋 ∈ �𝜋, 𝜋� is the observable profit for the P which is stochastically related

to 𝑒 by
𝑓 (𝜋|𝑒)
Microeconomics 2 Dr. F. Fatemi Page 199
Graduate School of Management and Economics – Sharif University of Technology
 For simplicity; assume 𝑒 is one dimensional and furthermore:
𝐸 = {𝑒𝐿 , 𝑒𝐻 }

Also assume that the effort is effective:

𝐹 (𝜋|𝑒𝐻 ) ≤ 𝐹 (𝜋|𝑒𝐿 ) for ∀𝜋 ∈ �𝜋, 𝜋�

&

𝐹 (𝜋|𝑒𝐻 ) < 𝐹 (𝜋|𝑒𝐿 ) over some open subset of �𝜋, 𝜋�

Equivalently:
𝜋 𝜋
� 𝜋𝑓(𝜋|𝑒𝐻 )𝑑𝜋 > � 𝜋𝑓 (𝜋|𝑒𝐿 )𝑑𝜋
𝜋 𝜋

Microeconomics 2 Dr. F. Fatemi Page 200

Graduate School of Management and Economics – Sharif University of Technology
 A is an expected utility maximizer; when she receives a wage of 𝑤 and
exerts effort of 𝑒
𝑢(𝑤, 𝑒)

Where for ∀𝑒, 𝑤:

𝜕𝑢(𝑤, 𝑒) 𝜕 2 𝑢(𝑤, 𝑒)
>0 , ≤0
𝜕𝑤 𝜕𝑤 2
𝑢(𝑤, 𝑒𝐻 ) < 𝑢(𝑤, 𝑒𝐿 )

We assume a linear separable utility function:

𝑢(𝑤, 𝑒) = 𝑣 (𝑤 ) − 𝑔(𝑒)
𝑣′ > 0 , 𝑣 ′′ ≤ 0 , 𝑔(𝑒𝐻 ) > 𝑔(𝑒𝐿 )

Microeconomics 2 Dr. F. Fatemi Page 201

Graduate School of Management and Economics – Sharif University of Technology
 Observable effort:

If 𝑢 is the A’s reservation utility, in a competitive market P makes A

indifferent between accepting and rejecting:

𝜋
max � �𝜋 − 𝑤 (𝜋)�𝑓 (𝜋|𝑒)𝑑𝜋
𝑒∈𝐸,𝑤(𝜋) 𝜋

𝜋
s. t. � 𝑣�𝑤 (𝜋)�𝑓 (𝜋|𝑒)𝑑𝜋 − 𝑔(𝑒) ≥ 𝑢
𝜋

The problem can be solved in two stages: 1) what is the best payment for
each level of 𝑒; and 2) what is the best level of 𝑒.

Microeconomics 2 Dr. F. Fatemi Page 202

Graduate School of Management and Economics – Sharif University of Technology
 The problem is equivalent to:
𝜋
min � 𝑤 (𝜋)𝑓 (𝜋|𝑒)𝑑𝜋
𝑤(𝜋) 𝜋

𝜋
s. t. � 𝑣�𝑤(𝜋)�𝑓 (𝜋|𝑒)𝑑𝜋 − 𝑔(𝑒) ≥ 𝑢
𝜋

If 𝜆 is the multiplier of the constraint in the optimization problem, then:

−𝑓 (𝜋|𝑒) + 𝜆 𝑣 ′ �𝑤 (𝜋)�𝑓 (𝜋|𝑒) = 0

And

′
1
𝑣 �𝑤 (𝜋)� =
𝜆

Microeconomics 2 Dr. F. Fatemi Page 203

Graduate School of Management and Economics – Sharif University of Technology
 If 𝑣 ′ (𝑤 ) < 0 (A is risk averse), then the optimal compensation scheme is
a constant which means P takes all the risk and fully insures A.

For each level of 𝑒, P offers a fixed wage payment of 𝑤𝑒∗ which solves:
𝑣 (𝑤𝑒∗ ) − 𝑔(𝑒) = 𝑢

Now P has to choose the optimal choice of 𝑒 which maximizes her profit
minus the wage
𝜋
� 𝜋𝑓 (𝜋|𝑒)𝑑𝜋 − 𝑣 −1 (𝑔(𝑒) + 𝑢)
𝜋

Microeconomics 2 Dr. F. Fatemi Page 204

Graduate School of Management and Economics – Sharif University of Technology
 Unobservable effort:
When effort was observable, it was possible to offer A, a contract which
1) specifies an efficient effort choice and 2) fully insures her.

With unobservable effort these two come into conflict.

i) Risk-neutral Agent:
Suppose 𝑣(𝑤 ) = 𝑤

The efficient (observable effort) level of effort 𝑒 ∗ solves:

𝜋
max � 𝜋𝑓(𝜋|𝑒)𝑑𝜋 − (𝑔(𝑒) + 𝑢)
𝑒∈𝐸 𝜋

Microeconomics 2 Dr. F. Fatemi Page 205

Graduate School of Management and Economics – Sharif University of Technology
 Suppose P offer the contract which offers 𝑤(𝜋) = 𝜋 − 𝛼

Accepting this contract A chooses 𝑒 to maximises her expected wage:

𝜋 𝜋
� 𝑤 (𝜋)𝑓 (𝜋|𝑒)𝑑𝜋 − 𝑔(𝑒) = � 𝜋𝑓(𝜋|𝑒)𝑑𝜋 − 𝛼 − 𝑔(𝑒)
𝜋 𝜋

It is trivial that 𝑒 ∗ which maximises this equals the efficient level of

effort.

A accepts the offer as long as

𝜋
� 𝜋𝑓 (𝜋|𝑒 ∗ )𝑑𝜋 − 𝛼 − 𝑔(𝑒 ∗ ) ≥ 𝑢
𝜋

Microeconomics 2 Dr. F. Fatemi Page 206

Graduate School of Management and Economics – Sharif University of Technology
 Then P should chooses 𝛼 ∗ as follows in order to make sure that A accepts
the contract
𝜋
𝛼 ∗ = � 𝜋𝑓(𝜋|𝑒 ∗ )𝑑𝜋 − 𝑔(𝑒 ∗ ) − 𝑢
𝜋

It means that if A is risk neutral, the P-A problem disappears; A bears all
the risk and A receives all marginal return from her effort.

Microeconomics 2 Dr. F. Fatemi Page 207

Graduate School of Management and Economics – Sharif University of Technology
 ii) Risk-averse Agent:

Again the problem should be solved in two stages:

1) Find the characteristics of the optimal contract for each level of

effort

2) Choose the effort level which P likes to induce

Microeconomics 2 Dr. F. Fatemi Page 208

Graduate School of Management and Economics – Sharif University of Technology
 The optimal incentive scheme for implementing
𝜋
min � 𝑤 (𝜋)𝑓 (𝜋|𝑒)𝑑𝜋
𝑤(𝜋) 𝜋

𝜋
s. t. � 𝑣�𝑤 (𝜋)�𝑓(𝜋|𝑒)𝑑𝜋 − 𝑔(𝑒) ≥ 𝑢
𝜋

𝜋
𝑒 = argmax � 𝑣�𝑤(𝜋)�𝑓(𝜋|𝑒̃ )𝑑𝜋 − 𝑔(𝑒̃ )
𝑒̃ 𝜋

The question is how P optimally implements each of the effort levels.

We consider the two cases in turn:

Microeconomics 2 Dr. F. Fatemi Page 209
Graduate School of Management and Economics – Sharif University of Technology
 Implementing 𝑒𝐿 :

P offers the fixed wage of

𝑤𝑒∗ = 𝑣 −1 (𝑔(𝑒𝐿 ) + 𝑢)

A accepts this contract and earns exactly 𝑢 bearing no risk.

Microeconomics 2 Dr. F. Fatemi Page 210

Graduate School of Management and Economics – Sharif University of Technology
 Implementing 𝑒𝐻 :

In this case 2nd constraint can be written as

𝜋 𝜋
� 𝑣�𝑤 (𝜋)�𝑓(𝜋|𝑒𝐻 )𝑑𝜋 − 𝑔(𝑒𝐻 ) ≥ � 𝑣�𝑤 (𝜋)�𝑓 (𝜋|𝑒𝐿 )𝑑𝜋 − 𝑔(𝑒𝐿 )
𝜋 𝜋

If 𝜆 and 𝜇 are the multipliers of the two constraints respectively, then

𝑤(𝜋) should satisfy the Kuhn-Tucker FOC at ∀𝜋 ∈ �𝜋, 𝜋�:

−𝑓(𝜋|𝑒𝐻 ) + 𝜆 𝑣 ′ �𝑤(𝜋)�𝑓(𝜋|𝑒𝐻 ) + 𝜇[𝑓 (𝜋|𝑒𝐻 ) − 𝑓 (𝜋|𝑒𝐿 )]𝑣 ′ �𝑤(𝜋)� = 0

Or
1 𝑓 (𝜋|𝑒𝐿 )
= 𝜆 + 𝜇 �1 − �
𝑣 �𝑤 (𝜋)�
′ 𝑓 (𝜋|𝑒𝐻 )
Microeconomics 2 Dr. F. Fatemi Page 211
Graduate School of Management and Economics – Sharif University of Technology
 We first show that in any solution which implements 𝑒𝐻 ; 𝜆 , 𝜇 > 0

1) suppose 𝜆 = 0.

𝐹 (𝜋|𝑒𝐻 ) ≤ 𝐹 (𝜋|𝑒𝐿 ) then there must be an open subset of �𝜋, 𝜋� where

𝑓(𝜋|𝑒𝐿 ) > 𝑓 (𝜋|𝑒𝐻 ); then considering that 𝜇 ≥ 0 this implies that
𝑣 ′ �𝑤 (𝜋)� ≤ 0 which is impossible.

2) suppose 𝜇 = 0.
Then P offers a fixed wage and as we said before in this case A chooses
𝑒𝐿 over 𝑒𝐻 which contradicts the second condition.

Microeconomics 2 Dr. F. Fatemi Page 212

Graduate School of Management and Economics – Sharif University of Technology
 Then both constraints bind when 𝑒 = 𝑒𝐻 .

1
Consider 𝑤
� such that = 𝜆; then:
𝑣 ′ (𝑤
�)

𝑤 (𝜋) > 𝑤
� if 𝑓 (𝜋|𝑒𝐿 ) < 𝑓 (𝜋|𝑒𝐻 )
And
𝑤 (𝜋) < 𝑤
� if 𝑓 (𝜋|𝑒𝐿 ) > 𝑓 (𝜋|𝑒𝐻 )

This means P pays more for the outcomes which are more likely to
happen when 𝑒 = 𝑒𝐻 .

It also means in an optimal incentive scheme to implement 𝑒𝐻 ; wage is

not necessarily increasing in profits.
Microeconomics 2 Dr. F. Fatemi Page 213
Graduate School of Management and Economics – Sharif University of Technology
 The positive relationship between the wage and profit in an optimal
compensation scheme happens only when 𝑓 (𝜋|𝑒𝐿 )/𝑓 (𝜋|𝑒𝐻 ) is decreasing
in profits. This property is known as monotone likelihood ratio property.

The compensation scheme also might have a complicated form in most of

problems.

Nonobservability increases P’s costs to implement 𝑒𝐻 .

Microeconomics 2 Dr. F. Fatemi Page 214

Graduate School of Management and Economics – Sharif University of Technology