Economics 410 Managerial Economics Thursday September 23, 1999

I. Incentive Contracting Game Theory concepts –Asymmetric Information –Moral Hazard –Adverse Selection Economics of Uncertainty Pure Theory of Insurance Preliminaries

I. Incentive Contracting “Bounded Rationality” Ideal would be complete contract specifications

The Big Issues Effort Ability to Monitor Uncertainty 4 th – Effort/Result

Chapter 7 Certainty Equivalent and Risk Premium

Certainty Equivalent I U(I)

Certainty Equivalent I U(Lottery) where mean is I

Certainty Equivalent I Utility of uncertain prospect CE CE +RiskPrem = I RiskPrem = ½ r Var(I)

Three Concepts Certainty Equivalent – what certain prospect is equivalent to some lottery Expected Value (Income, for Example) Risk Premium = ½ r Var(I) CE = I – ½ r Var(I) R is the coefficient of absolute risk aversion

The Wage Equation W =  +  (e + x +  y) Observed elements z and y Bargain over , ,  Where z = e + x (z might be sales) y might be industry sales

Employer Revenue P ( e ) Employee Cost of Effort C ( e )

The Wage Equation W =  +  (e + x +  y) Employee’s Certainty Equivalent E(I) – ½ r Var (I)  +  e –C(e) – ½ r  2 Var(x +  y) Employer’s Certainty Equivalent P(e) – (  +  e)

The “Incentive Constraint” Employee’s Certainty Equivalent  +  e –C(e) – ½ r  2 Var(x +  y) Maximize the above, choosing e  - C ‘ ( e ) = 0

“Informativeness Principle” Reducing “unnecessary variance”

Incentive-Intensity Principle

The End