1. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-1 Topics 1.The Principal-Agent Problem. 2.Using Contracts to Reduce Moral Hazard. 3.Monitoring to Reduce Moral Hazard. 4.Checks on Principals. 5.Contract Choice.

2. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-2 The Principal-Agent Problem The principal, Paul, owns many ice cream parlors across North America. Paul contracts with Amy, the agent, to manage his Miami shop. Her duties include supervising workers, purchasing supplies, and performing other necessary actions.

3. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-3 The Principal-Agent Problem (cont.) The shop’s daily earnings depend on the local demand conditions and on how hard Amy works. Demand for ice cream varies with the weather, and is high half the time, and low otherwise.

4. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-4 Efficiency Efficient contract - an agreement in which neither party can be made better off without harming the other party. Efficiency in production - situation in which the principal’s and agent’s combined value (profits, payoffs), π, is maximized.

5. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-5 Efficiency (cont.) Efficiency in risk bearing - a situation in which risk sharing is optimal in that the person who least minds facing risk—the risk-neutral or less risk-averse person— bears more of the risk.

6. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-6 Symmetric Information Moral hazard is not a problem if Paul lives in Miami and can directly supervise Amy. They could agree to a contract that specifies Amy receives 200 per day if she works extra hard, but loses her job if she doesn’t.

7. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-7 Symmetric Information (cont.) Amy bears no risk: She receives 200 regardless of demand conditions. Paul is the residual claimant: He receives the residual profit, which is the amount left over from the store’s profit after Amy’s wage is paid. This result is called perfect monitoring: this contract is efficient because Paul, the risk- neutral party, bears all the risk, and their combined earnings are as high as possible because Amy works extra hard.

8. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-8 Table 20.1 Ice Cream Shop Outcomes

9. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-9 Asymmetric Information Fixed-fee contract - one party pays the other a constant payment or fee. Because Amy receives the same amount no matter how hard she works, Amy chooses not to work hard, which is a moral hazard problem. Paul bears all the risk, so risk bearing is again efficient. However, the expected combined earnings are less than in the previous example with symmetric information.

10. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-10 Solved Problem 20.1 Traditionally the Las Vegas Home Bank made only prime loans—providing mortgages just to people who were very likely to repay the loans. However, Leonardo, a senior executive at the bank, is considering offering subprime loans—mortgages to speculators and other less creditworthy borrowers. If he makes only prime loans, the bank will earn $160 million. If he also makes subprime loans, the bank will make a very high profit, $800 million, if the economy is good so that few people default. However, if the economy is bad, the large number of defaults will cause the bank to lose $320 million.

11. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-11 Solved Problem 20.1 (cont.) The probability that the economy is bad is 75%. Leonardo will receive 1% of the bank’s profit if it is positive. He believes that if the bank loses money, he can walk away from his job without repercussions but with no compensation. Leonardo and the bank’s shareholders are risk neutral. Does Leonardo provide subprime loans if all he cares about is maximizing his personal expected earnings? What would the bank’s stockholders prefer that Leonardo do (given that they know the risks involved)?

12. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-12 Solved Problem 20.1: Answer 1.Compare the bank’s expected return on the two types of mortgages. 2.Compare the manager’s expected profits on the two investments. 3.Compare the shareholders’ expected profits on the two types of mortgages.

13. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-13 Fixed-Fee Contracts Amy could pay Paul a fixed amount so that she receives the residual profit. Amy is, in effect, paying a license fee to operate Paul’s ice cream shop. With such a contract, Paul bears no risk as he receives a fixed fee, while Amy bears all the risk. This contract maximizes combined expected earnings, it does not provide for efficient risk bearing.

14. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-14 State-Contingent Contracts State-contingent contracts - one party’s payoff is contingent on only the state of nature. Suppose Amy pays Paul a license fee of 100 if demand is low and a license fee of 300 if demand is high and keeps any additional earnings. This state-contingent contract is fully efficient even if Paul cannot monitor Amy’s effort.

15. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-15 Solved Problem 20.2 Gary’s demand for doctor visits depends on his health. Half the time his health is good and his demand is D 1 on the graph. When his health is poor, his demand is D 2. Without medical insurance, he pays $50 a visit. With full insurance, Gary pays a fixed fee at the beginning of the year, and the insurance company pays the full cost of any visit.

16. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-16 Solved Problem 20.2 (cont.) Alternatively, with a contingent contract, Gary pays a smaller premium at the beginning of the year, and the insurance company covers only $20 per visit and Gary pays the remaining $30. How likely is a moral hazard problem to occur with each of these contracts? What is Gary’s risk (variance of his medical costs) with no insurance and with each of the two types of insurance? Compare the contracts in terms of the trade-offs between risk and moral hazard.

17. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-17 Solved Problem 20.2 (cont.)

18. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-18 Solved Problem 20.2: Answer 1.Describe the moral hazard for each demand curve for each contract. 2.Calculate the variance of Gary’s medical expenses for no insurance and for the two insurance contracts. 3.Discuss the trade-offs.

19. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-19 Profit-Sharing Contracts Profit-Sharing Contracts - in which the payoff to each party is a fraction of the observable total profit. Profit sharing may reduce or eliminate the moral hazard problem, especially if the agent’s share of the profit is large, but may not do so if the agent’s share is small.

20. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-20 Solved Problem 20.3 Penny, the owner of a store, makes a deal with Arthur, her manager, that at the end of the year, she receives two-thirds of the store’s profit and he gets one-third. If Arthur is interested in maximizing his earnings, will Arthur act in a manner that maximizes the store’s total profit (which both Penny and Arthur can observe)? Answer using a graph.

21. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-21 Solved Problem 20.3: Answer

22. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-22 Bonuses and Options Bonus - an extra payment if a performance target is hit. Option - gives the holder the right to buy up to a certain number of shares of the company at a given price (the exercise price) during a specified time interval.

23. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-23 Piece Rates Piece-rate contract - in which the agent receives a payment for each unit of output the agent produces. Owners often use piece rates if they can observe output but not labor.

24. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-24 Commissions When at least one party cannot observe total profit, but both can observe revenue, they use a revenue-sharing contract: the agent receives a share of the revenue. For people who work in sales, such payments are called commissions.

25. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-25 Solved Problem 20.4 Peter, the owner of a firm, pays his salesperson, Ann, a commission on her sales (revenue). Thus, Ann has an incentive to maximize revenue. The graph shows how revenue and profit vary with output. Show that if she succeeds in maximizing revenue that she does not maximize the firm’s profit.

26. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-26 Solved Problem 20.4 (cont.)

27. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-27 Choosing the Best Contract Which contract is best for a principal and an agent depends on their attitudes toward risk, the degree of risk, the difficulty in monitoring, and other factors. Contingent fee - a payment to a lawyer that is a share of the award in a court case (usually after legal expenses are deducted) if the client wins and nothing if the client loses.

28. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-28 Monitoring to Reduce Moral Hazard Monitoring eliminates the asymmetric information problem: –Both the employee and the employer know how hard the employee works. Shirking - a moral hazard in which agents do not provide all the services they are paid to provide.

29. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-29 Bonding Performance bond - an amount of money that will be given to the principal if the agent fails to complete certain duties or achieve certain goals.

30. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-30 Bonding to Prevent Shirking Suppose that the value that a worker puts on the gain from taking it easy on the job is G dollars. If a worker’s only potential punishment for shirking is dismissal if caught, some workers will shirk.

31. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-31 Bonding to Prevent Shirking (cont.) Suppose that the worker must post a bond of B dollars that the worker forfeits if caught not working. Given the firm’s level of monitoring, the probability that a worker is caught is θ. Thus, a worker who shirks expects to lose θB.

32. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-32 Bonding to Prevent Shirking (cont.) A risk neutral worker chooses not to shirk if the certain gain from shirking, G, is less than or equal to the expected penalty, θB, from forfeiting the bond if caught: G ≤ θB. The minimum bond that discourages shirking is

33. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-33 Trade-Off Between Bonds and Monitoring The larger the bond, the less monitoring is necessary to prevent shirking. Suppose that a worker places a value of G = $1,000 a year on shirking. A bond that is large enough to discourage shirking is –$1,000 if the probability of being caught is 100%, –$2,000 at 50%, –$5,000 at 20%, –$10,000 at 10%, and –$20,000 if the probability of being caught is only 5%.

34. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-34 Solved Problem 20.5 Workers post bonds of B that are forfeited if they are caught stealing (but no other punishment is imposed). Each extra unit of monitoring, M, raises the probability that a firm catches a worker who steals, θ, by 5%. A unit of M costs $10. A worker can steal a piece of equipment and resell it for its full value of G dollars. What is the optimal M that the firm uses if it believes that workers are risk neutral? In particular, if B = $5,000 and G = $500, what is the optimal M ?

35. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-35 Solved Problem 20.5: Answer 1.Determine how many units of monitoring are necessary to deter stealing. 2.Determine whether monitoring is cost effective. 3.Solve for the optimal monitoring in the special case.

36. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-36 Problems with Bonding To capture a bond, an unscrupulous employer might falsely accuse an employee of stealing. Workers may not have enough wealth to post them.

37. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-37 Deferred Payments A firm may offer its workers one of two wage payment schemes. –The firm pays w per year for each year that the worker is employed by the firm. –The starting wage is less than w but rises over the years to a wage that exceeds w.

38. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-38 Efficiency Wages Efficiency wage - an unusually high wage that a firm pays workers as an incentive to avoid shirking. Suppose that a firm pays each worker an efficiency wage w, which is more than the going wage w that an employee would earn elsewhere after being fired for shirking.

39. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-39 How Efficiency Wages Act like Bonds A shirking worker expects to lose θ(w − w), –where θ is the probability that a shirking worker is caught and fired. A risk-neutral worker does not shirk if the expected loss from being fired is greater than or equal to the gain from shirking: θ(w − w) ≥ G.

40. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-40 How Efficiency Wages Act like Bonds (cont.) The smallest amount by which w can exceed w and prevent shirking is determined:

41. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-41 Checks on Principals Sometimes the principal may have asymmetric information and engage in opportunistic behavior. Because employers (principals) often pay employees (agents) after work is completed, employers have many opportunities to exploit workers.

42. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-42 Checks on Principals (cont.) Strategies to prevent opportunist behavior by principals: –Requiring that a firm post a bond. –Requiring the employer to reveal relevant information to employees.

43. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-43 Application Layoffs Versus Pay Cuts

44. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-44 Application Layoffs Versus Pay Cuts (cont.)

45. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-45 Contract Choice Often a principal gives an agent a choice of contract. By observing the agent’s choice, the principal obtains enough information to prevent agent opportunism.

46. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-46 Contract Choice (cont.) The firm seeks to avoid moral hazard problems by preventing adverse selection, –whereby lazy employees falsely assert that they are hardworking. Signal Screen out

47. Copyright ©2015 Pearson Education, Inc. All rights reserved.20-47 Table 20.2 Firm’s Spreadsheet