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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</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.</p> Signup and view all the answers

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

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

    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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