1. 3016:Economics of Information Elements of the Principal Agent model Part 3. 10 th October

2. The principal-agent (PA) model Previous class: EI will study what type of contracts will emerge when information is asymmetric The basic tool to study this is the commonly called principal-agent model We need a relationship with at least two parts to study the contracts that will emerge. One part will be called a principal and the other an agent

3. The PA model Relationship between two parts. Bilateral relationship One party contracts another to carry out some type of action or take some decision  Contractor=principal  Contractee=agent  Shareholder vs. Manager, Shop owner vs. Shop assistant If they agree, they will sign a contract A contract can only contain verifiable variables

4. When is a variable verifiable? A variable is verifiable if a contract that depends on it can be enforced A third party (arbitrator, court) can verify the value of the variable and make the parties to fulfill the contract Example, wage equals 10% of sales The shop assistant can take the shop owner to court if he does not pay the wage according to the above example

5. What is a contract? A contract is a document that specifies the obligations of the participants, and the transfers that must be make under different contingencies Usually, a contract is a set of payments that depend on the value of different variables It is useless to specify variables is the contract that are not verifiable. Parties will not sign contracts that depend on no verifiable information as they know that it might not be respected by others Contract: [Wage equals 10% of “shop assistant’s kindness to the public”] cannot be enforced because kindness is no verifiable (a court of law cannot measure it and take legal action accordingly) Contracts will only depend on verifiable variables What is verifiable or not depends on the technology, environment

6. Information and verifiability We say that information is symmetric if all the parties know the same about the variables that are no verifiable and affect the value of the relationship We say that information is asymmetric if one party knows more than the other about no verifiable variables that affect the value of the relationship Example The shop assistant knows more about his kindness to the public than the shop owner. Kindness to the public influences sales and it is not verifiable. This is a situation with asymmetric information. Asymmetric Information cannot be caused by asymmetric knowledge of verifiable variables