Behavioural Economics: Principal-Agent Problem
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Questions and Answers

What is a key characteristic of the new contract proposed in the discussion?

  • Workers receive only commission without a base pay.
  • Workers earn a fixed base pay as long as they keep their job. (correct)
  • Workers are paid a flat fee regardless of sales performance.
  • Workers must sell more than Q0 to earn any incentive pay. (correct)

What happens if the draw, D, is set too generously in the incentive pay plan?

  • The agent will always achieve their sales targets.
  • Point n will lie below the indifference curve.
  • The agent may become less motivated to sell higher amounts. (correct)
  • The fixed base pay will become irrelevant for performance.

Which of the following correctly describes the relationship between the draw, D, and the output needed to maintain job security, Q0?

  • D must be equal to Q0 for the contract to be effective.
  • D should be generous to ensure job retention regardless of sales.
  • D cannot be too generous relative to the required output, Q0. (correct)
  • D must always exceed Q0 to motivate the worker.

What condition must be met for the new incentive plan to yield the same results as the original pay plan?

<p>The draw, D, must not be too generous. (B)</p> Signup and view all the answers

In the proposed new contract, what happens if the worker sells less than the minimum required amount?

<p>The worker still receives their fixed base pay. (B)</p> Signup and view all the answers

What is described as the ‘franchise solution’ to the principal-agent problem?

<p>Selling the job to the worker, allowing them to keep all earnings. (D)</p> Signup and view all the answers

What does the phrase ‘Buy, don’t make’ imply in a business context?

<p>Purchasing goods from vendors can lead to better financial outcomes. (A)</p> Signup and view all the answers

What does the participation constraint require in terms of agent utility?

<p>The agent must reach a specific target utility level. (C)</p> Signup and view all the answers

What is a reason workers may hesitate to make a large up-front payment for a job?

<p>They may lack trust in the employer for returns. (C)</p> Signup and view all the answers

What relationship is established between base pay and target utility in the principal’s problem?

<p>Higher base pay is needed for higher target utility. (A)</p> Signup and view all the answers

In the context of implicit payment for jobs, what does building the entry fee into the worker's pay schedule allow?

<p>Workers to afford the job without upfront payments. (D)</p> Signup and view all the answers

What is the implication of setting a 100% commission rate for the agent's pay?

<p>Agent pay increases in direct proportion to revenue contribution. (B)</p> Signup and view all the answers

How does a commission-based pay affect a worker's income according to the principal-agent problem?

<p>It ties their income directly to their performance. (A)</p> Signup and view all the answers

Why might a worker's income be less than what they produce, leading to profits being shown as a vertical distance on a graph?

<p>There are costs associated with the job that are deducted. (C)</p> Signup and view all the answers

What does the incentive compatibility constraint relate to in the principal’s problem?

<p>The agent’s effort must align with the firm's profit goals. (C)</p> Signup and view all the answers

What happens when a worker cannot afford to pay upfront for a job?

<p>They may be unable to take the job in the first place. (A)</p> Signup and view all the answers

Why might a principal not need to give an agent as much pay to achieve a certain utility level?

<p>Incentives can be adjusted through alternative methods. (D)</p> Signup and view all the answers

In deriving the profit function in the principal’s problem, which step involves taking the derivative with respect to base pay?

<p>Calculating the optimal commission rate. (D)</p> Signup and view all the answers

Which of the following best describes agency problems in a business context?

<p>Issues arising from a misalignment of interests between parties in a contract. (B)</p> Signup and view all the answers

What factor is indicated as not influencing the principal’s decision about the commission rate?

<p>The level of utility set for the agent. (D)</p> Signup and view all the answers

What is the outcome of not establishing a profit-maximizing contract for the principal?

<p>The agent may not perform effectively. (A)</p> Signup and view all the answers

What effect does raising the slope parameter of the employment contract have on the agent's effort?

<p>It makes the agent work harder. (C)</p> Signup and view all the answers

What is the primary goal of the Principal's problem?

<p>To ascertain the appropriate commission rate and payment structure. (A)</p> Signup and view all the answers

In the warm-up problem, what are we primarily ignoring while solving for profits?

<p>The agent’s participation constraint. (B)</p> Signup and view all the answers

Which statement accurately describes the impact of changing the intercept parameter of the employment contract?

<p>It has no effect on the agent's optimal effort. (A)</p> Signup and view all the answers

What does the first-order condition for maximum profits indicate?

<p>A commission rate of 50% maximizes profits. (D)</p> Signup and view all the answers

What was the assumed contract in the warm-up problem?

<p>A contract primarily benefiting the principal. (A)</p> Signup and view all the answers

Why is the warm-up problem considered misleading in the context of the Principal-Agent problem?

<p>It incorrectly identifies how to elicit agent's efforts. (D)</p> Signup and view all the answers

What must be satisfied in the principal’s profit-maximizing strategy?

<p>The agent’s incentive-compatibility constraint. (D)</p> Signup and view all the answers

What is the first key stage in the Principal-Agent Problem?

<p>The principal and agent set the rules of the contract. (C)</p> Signup and view all the answers

Which of the following best describes the agent's role in the Principal-Agent Problem?

<p>The agent takes the contract and maximizes his own utility. (A)</p> Signup and view all the answers

In the production function used in the example, how is effort measured?

<p>By the number of units produced. (C)</p> Signup and view all the answers

What does the term 'reaction function' refer to in the context of the Principal-Agent Problem?

<p>The agent's expected response to the contract set by the principal. (B)</p> Signup and view all the answers

Why can the principal not base the contract directly on the agent's effort?

<p>The principal cannot observe the effort level directly. (D)</p> Signup and view all the answers

What is the assumed relationship between marginal costs of effort and the effort level in the agent's utility?

<p>Marginal costs increase as effort increases. (D)</p> Signup and view all the answers

What is the purpose of the optimal contract in the Principal-Agent model?

<p>To align the interests of the principal and agent. (C)</p> Signup and view all the answers

In the example of the Principal-Agent Problem, what is the primary output being observed?

<p>Dollars of net revenue. (D)</p> Signup and view all the answers

What does the cost of effort function represent in the Principal-Agent Problem?

<p>The baseline costs associated with the agent's effort. (A)</p> Signup and view all the answers

What does an indifference curve indicate in the context of the Principal-Agent Problem?

<p>The amount the principal has to pay to maintain a utility level. (D)</p> Signup and view all the answers

How can the contract between the principal and agent be expressed?

<p>As a combination of base pay and a piece rate. (C)</p> Signup and view all the answers

What does the agent’s participation constraint imply?

<p>The agent should achieve a utility level higher than their alternative options. (D)</p> Signup and view all the answers

When establishing a contract, how does the principal decide on the agent's utility level?

<p>By choosing a level that allows the principal to maximize their own profits. (B)</p> Signup and view all the answers

What characterizes linear piece rate contracts as discussed?

<p>They link compensation to the net revenue generated by the agent’s efforts. (C)</p> Signup and view all the answers

What does the slope of an indifference curve represent in this context?

<p>The change in wage relative to the agent's effort. (B)</p> Signup and view all the answers

In maximizing profits, what is the principal's goal regarding the agent's utility?

<p>To set utility at a level that ensures agent acceptance of the contract. (C)</p> Signup and view all the answers

Flashcards

Principal-Agent Problem

A situation where one party (the principal) delegates a task to another party (the agent) and cannot directly monitor their effort.

Contract

The contract or rules that govern the relationship between the principal and agent.

Reaction Function

The agent's response to the contract, which is determined by maximizing their own utility, given the rules of the contract.

Backwards Induction

The process of solving the principal-agent problem by working backward from the agent’s reaction function to find the optimal contract that aligns the agent's incentives with the principal's goals.

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Production Function

The relationship between effort and output.

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Productivity Parameter

A parameter that represents factors like ability or technology that influence the relationship between effort and output.

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Agent's Utility

The agent's goal of maximizing their own utility, which is represented by a function that considers income and the cost of effort.

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Increasing Marginal Costs of Effort

The idea that each additional unit of effort becomes increasingly difficult or costly for the agent.

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Warm-up Problem

This is a simplified version of the Principal-Agent problem focusing on how the principal can maximize profits by adjusting the commission rate alone.

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Incentive-Compatibility Constraint

The agent's response to the contract, showing how their effort level changes based on the commission rate.

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Agent's Effort = Commission Rate

The agent's effort is directly proportional to the commission rate, suggesting a simple relationship between compensation and output.

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Principal's Profit Maximization

The principal wants to find the commission rate that maximizes profits while ensuring the agent is motivated to work.

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Marginal Profit

The change in profits for each additional unit of effort.

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Optimal Commission Rate

The commission rate that maximizes the principal's profits.

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First-Order Condition

The mathematical formula for maximizing profits in this scenario, considering the agent's reaction to the commission rate.

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50% Commission Rate

The commission rate that maximizes profits, determined to be 50% of net revenue.

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Cost of Effort Function

The relationship between the agent's effort level and the cost of exerting that effort. This function typically assumes that the cost of effort rises as the agent exerts more effort.

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Participation Constraint

The agent's decision to accept or reject the contract, based on whether the utility they expect to receive from the contract is greater than their utility from the outside option.

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Indifference Curve

A mathematical representation of the agent's preferences, showing combinations of effort and pay that provide the agent with the same level of utility. Higher indifference curves represent higher levels of utility.

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Linear Piece Rate Contract

A straightforward contract structure where the agent's pay is determined by a fixed base amount plus a per-unit payment (the 'piece rate') for each unit of output produced.

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Principal’s Objective

The principal's goal of maximizing profit, taking into account the agent's actions and the costs of effort.

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Franchise Solution

A solution to the principal-agent problem where the agent essentially "buys" the job or task from the principal, bearing the full costs and reaping all the rewards.

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Implicit Payment for Jobs

A strategy that seeks to address the principal-agent problem by building an entry fee for the job into the worker's pay schedule.

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Balancing Commission and Entry Fee

A situation where a worker who doesn't have the upfront capital to buy a job can still profit from it if their commission rate is high enough to compensate for the implicit entry fee.

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Profit from the Optimal Commission Rate

The difference between the value the worker produces and their earnings at the optimal commission rate.

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Profit-Maximizing Commission Rate

The optimal commission rate, in this context, is the one that maximizes the principal's profit while taking into account the agent's effort and utility. It's about finding the sweet spot where both parties benefit.

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Optimal Commission Rate (Warm-Up)

The optimal commission rate in the warm-up problem is 100%. This means the agent receives one dollar for every dollar of net revenue generated, aligning their incentives perfectly with the principal's goal.

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Principal's Problem

The principal's problem revolves around designing a contract that maximizes their profit while ensuring the agent remains motivated to exert effort. It's about finding the balance between cost and incentive.

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Principal's Profit

The principal's profit depends on both the effort level of the agent (which influences output) and the commission rate. The goal is to find the right commission rate that leads to maximum profit.

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Fixed Base Pay with Commission Threshold

A contract where the agent receives a fixed base pay, but only earns a commission on units sold above a certain threshold. The agent still receives a positive 'draw', meaning they get paid even if they don't sell anything, but must meet a minimum requirement to earn additional commission.

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Generous Draw Contract

A contract where the principal offers a fixed base pay that is generous enough so that even if the agent doesn't meet any sales requirements, they still choose to work and exert some effort. This prevents the agent from simply doing the bare minimum or quitting.

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Principal's Optimization

The principal’s objective is to maximize their profits by finding a contract that motivates the agent to exert effort. This often involves finding a balance between the agent’s desire for higher pay and the principal’s desire to minimize costs.

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Equivalent Contract

In this context, it means a contract that provides the same output and utility as the original contract structure, but uses a different combination of base pay and commission rates.

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Study Notes

Behavioural Economics of Organizations - Principal-Agent Problem

  • This study explores employee motivation through the principal-agent model, a simple theoretical model of optimal financial incentive design.
  • The model uses an example of a person injured in a big box store needing legal representation.
  • The optimal compensation of a lawyer involves understanding incentives.
  • The principal-agent problem has a timeline of actions:
    • Principal offers employment contract.
    • Agent accepts or rejects contract (participation constraint).
    • Agent chooses effort, impacting output (incentive compatibility constraint).
    • Agent is paid and profits are realized.
  • The solution to the problem is through backwards induction:
    • First, determine the agent's expected reaction under given rules.
    • Second, derive the optimal contract/rules given the predicted response.
  • Key characteristics of the example used:
    • Single principal, single agent.
    • No uncertainty.
    • One observable output (Q), representing net revenue.
    • Effort (E) is not directly observable.
    • Output (Q) is related to effort by the production function: Q = dE (d > 0 affects productivity).
  • The baseline production function is Q = E. This function describes a fixed relationship, where effort (E) directly determines output (Q).
  • The agent's utility function is U = Y - V(E), where Y is income and V(E) is effort cost. Increasing marginal costs of effort are assumed (V'>0, V''>0)
  • V(E) = E2/2 is a typical cost of effort function, demonstrating increasing marginal cost of effort.
  • The utility function curve creates an indifference map that can show how much the agent needs to be paid (Y) to maintain a certain utility level (U) for varying effort level (E). The slope of the indifference curve is dY/dE = V'(E).
  • The contract is (a,b), where
    • a = base pay.
    • b = piece-rate; per dollar of net revenue generated by agent.
  • Assuming the agent's alternative utility is (Ualt), the agent's participation constraint is U ≥ Ualt.
  • The agent's problem is to maximise U = Y - V(E), given the employment contract (a,b).
    • The solution is E = b (Optimal level of effort).
    • A higher piece rate(b), results in higher effort.
    • Agent’s choice of effort depends only on the piece rate, b.
  • The principal's problem is to derive the appropriate commission rate (b) and base pay (a), maximizing profit, given that the agent has an optimal choice of effort (E).
  • The optimal commission rate (b) is 0.5 (50%), maximizing profit. This result doesn't depend on the Ualt , nor the starting base pay (a).
  • Even if a is high, b (the piece rate) must be at least 50%.
  • In the more generalized model, the optimal commission b always lies strictly between 0 and 1.
  • In the 'warm-up' problem, using a = 0 in maximize-profit functions, the optimal piece rate is b*=0.5. For a general approach, the optimal piece rate is 1.
  • A contract that doesn't provide a worker with a positive base pay is considered the "franchise solution" by some economists.
  • Selling a job is used by firms that require highly motivated workers.
  • Examples of jobs sold by firms include (but are not limited to) hairdressers, drivers (e.g., Uber), and real estate agents who get paid commission rates. -The principle can improve efficiency by raising the piece rate, b. -Agents can be incentivised by adjusting base pay, a, for different levels of utility, Ualt.
  • Consider a sales person who gets paid monthly net sales (Q). The optimal reward schedule is such that Y = a + Q where Q > Qo. If Q < Qo, then Y = 0.

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Description

This quiz delves into the principal-agent problem in the context of behavioral economics. It examines how employment contracts and incentive designs affect employee motivation and performance. By analyzing a case involving legal representation, the course provides insights into optimal compensation strategies and decision-making processes.

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