ch 14 agency
DESCRIPTION
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 - PowerPoint PPT PresentationTRANSCRIPT
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
• Smith provides tools and a shop• Jones provides labor• Suppose the relationship is initially 50-50
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
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
Who is to be the monitor?
• The party with the least incentive to shirk• The least mobile party
Who is to be the monitor?
• For efficiency- the party central to all contracts
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
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
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
Math Example
• Thus, the cost to the firm is:
• C = 1000 + e2
Math example
• Suppose the firm benefits by $100 for each extra unit of effort made by the employee
• B = 100e
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
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
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
Problem
• If the salary is fixed at $3,500 and “e” is not costlessly observable
Problem
• If the salary is fixed at $3,500 and “e” is not costlessly observable
• then worker has the incentive to shirk
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?
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
Piece Rate Contract
• Pays a fee for each unit of output
• This provides incentives for worker to work
• possibly producing too much
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
Math Example
• Suppose “e” cannot be observed but gross revenue can be
• Suppose gross revenue depends on worker’s effort plus other factors
Revenue = f(e, X)
B =5000 B = 4000
e = 50 Prob=3/4 Prob=1/4
e = 40 Prob=1/4 Prob=3/4
Incentive Compatibility
• Establish a salary structure so that workers • U(e =50) > U(e=40)
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)
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
• What happens when the riskiness of those revenues falls?
• What happens when the riskiness of those revenues falls?
• You reduce the premium paid for the higher productivity
Other Shirking Deterrents
• Bonding
Other Shirking Deterrents
• Bonding• Back-loading
Other Shirking Deterrents
• Bonding• Back-loading• Bonuses
Other Shirking Deterrents
• Bonding• Back-loading• Bonuses• Promotions