Agency: Incentives and Asymmetric Information

In course

Description

This lecture explores the concept of agency, focusing on the principal-agent model and the optimal contract design. It delves into the importance of incentives in aligning the interests of agents with principals, highlighting the challenges posed by asymmetric information where agents have more knowledge than principals. The lecture discusses how agency relationships are pervasive in economic and non-economic contexts, illustrating examples such as landowner/farmer and shareholder/CEO relationships. It also covers the implications of asymmetric information, including moral hazard and adverse selection, and how agents can exploit their informational advantage. Additionally, the production technology and contract design in the presence of asymmetric information are examined.

Instructors (2)

Official source

https://mediaspace.epfl.ch/media/0_97awfql1

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Related concepts (34)

Contract theory

From a legal point of view, a contract is an institutional arrangement for the way in which resources flow, which defines the various relationships between the parties to a transaction or limits the rights and obligations of the parties. From an economic perspective, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of information asymmetry. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as law and economics.

Principal–agent problem

The principal–agent problem refers to the conflict in interests and priorities that arises when one person or entity (the "agent") takes actions on behalf of another person or entity (the "principal"). The problem worsens when there is a greater discrepancy of interests and information between the principal and agent, as well as when the principal lacks the means to punish the agent. The deviation from the principal's interest by the agent is called "agency costs".

Information asymmetry

In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge. A common way to visualise information asymmetry is with a scale, with one side being the seller and the other the buyer.

Adverse selection

In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is the unequal distribution of benefits to both parties, with the party having the key information benefiting more. In an ideal world, buyers should pay a price which reflects their willingness to pay and the value to them of the product or service, and sellers should sell at a price which reflects the quality of their goods and services.

Moral hazard

In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk knowing that its insurance will pay the associated costs. A moral hazard may occur where the actions of the risk-taking party change to the detriment of the cost-bearing party after a financial transaction has taken place.