Podcast
Questions and Answers
Economically efficient contracts aim to:
Economically efficient contracts aim to:
- Maximize the sum of the principal's profits and the agent's utility. (correct)
- Maximize the principal's profits only.
- Maximize the agent's utility only.
- Minimize the principal's costs.
If payments from a firm to an agent increase, the firm's economic welfare, as defined in the material, increases.
If payments from a firm to an agent increase, the firm's economic welfare, as defined in the material, increases.
False (B)
In the context of contract theory, what commission rate is generally considered optimal when maximizing the size of the pie, regardless of how it's divided?
In the context of contract theory, what commission rate is generally considered optimal when maximizing the size of the pie, regardless of how it's divided?
100%
The social surplus equals the total amount produced minus the cost of __________ it.
The social surplus equals the total amount produced minus the cost of __________ it.
Match the economic terms with their descriptions:
Match the economic terms with their descriptions:
In the context of the principal-agent problem with a baseline production function and cost of effort, what commission rate (b) maximizes the sum of the principal's profits and the agent's utility, subject to the incentive-compatibility constraint?
In the context of the principal-agent problem with a baseline production function and cost of effort, what commission rate (b) maximizes the sum of the principal's profits and the agent's utility, subject to the incentive-compatibility constraint?
In a principal-agent model, maximizing the agent's utility while considering the incentive-compatibility constraint will always result in a commission rate of b=0.
In a principal-agent model, maximizing the agent's utility while considering the incentive-compatibility constraint will always result in a commission rate of b=0.
In a scenario where uncertainty is introduced into the principal-agent model via a random variable added to the output function, what does setting b=1 expose the worker to?
In a scenario where uncertainty is introduced into the principal-agent model via a random variable added to the output function, what does setting b=1 expose the worker to?
When firms are risk neutral and workers are risk _____, it may be socially optimal for firms to insure workers against production uncertainty.
When firms are risk neutral and workers are risk _____, it may be socially optimal for firms to insure workers against production uncertainty.
In a situation of uncertainty with risk-averse workers and risk-neutral firms, insurance could take the form of:
In a situation of uncertainty with risk-averse workers and risk-neutral firms, insurance could take the form of:
When firms and workers can write and enforce employment contracts that depend on the state of nature, these are known as state-independent contracts.
When firms and workers can write and enforce employment contracts that depend on the state of nature, these are known as state-independent contracts.
In the context of state-contingent contracts, instead of stipulating a single ordered pair (a, b), what can these contracts stipulate for each possible state of nature?
In the context of state-contingent contracts, instead of stipulating a single ordered pair (a, b), what can these contracts stipulate for each possible state of nature?
The profit-maximizing state-contingent contract for risk-averse workers sets b=1 in all states, but _____ workers by offering a higher intercept (a) in worse states of nature.
The profit-maximizing state-contingent contract for risk-averse workers sets b=1 in all states, but _____ workers by offering a higher intercept (a) in worse states of nature.
Match the following compensation adjustments with their impact on risk allocation in state-contingent contracts for risk-averse workers:
Match the following compensation adjustments with their impact on risk allocation in state-contingent contracts for risk-averse workers:
In state-contingent employment contracts, what action can firms take to implement optimal contracts without requiring workers to "pay for their jobs?"
In state-contingent employment contracts, what action can firms take to implement optimal contracts without requiring workers to "pay for their jobs?"
In the context of economically efficient contracts, maximizing social surplus is independent of how the surplus is ultimately divided between the principal and the agent.
In the context of economically efficient contracts, maximizing social surplus is independent of how the surplus is ultimately divided between the principal and the agent.
How do state-contingent contracts help in stabilizing take-home pay for risk-averse agents?
How do state-contingent contracts help in stabilizing take-home pay for risk-averse agents?
To add uncertainty to the principal-agent model, _____ is now defined as $Q = dE + \epsilon$, where $\epsilon$ is a random variable with a mean of zero.
To add uncertainty to the principal-agent model, _____ is now defined as $Q = dE + \epsilon$, where $\epsilon$ is a random variable with a mean of zero.
According to the material, which factor motivates firms to insure risk-averse workers against production uncertainty?
According to the material, which factor motivates firms to insure risk-averse workers against production uncertainty?
Match each variable with its meaning:
Match each variable with its meaning:
Flashcards
Economically efficient contracts
Economically efficient contracts
Contracts that maximize the sum of the principal's profits and the agent's utility, represented as W = Î + U.
Payments effect on welfare
Payments effect on welfare
Payments from the firm to the agent (Y) make the firm worse off and the agent better off. The total amount the firm pays the worker subtracts out of our definition of social welfare.
Social Surplus Calculation
Social Surplus Calculation
Social surplus equals the total amount produced (Q) minus the cost of producing it (V(E)).
Optimal contract commission
Optimal contract commission
Signup and view all the flashcards
The Economically Efficient Contract
The Economically Efficient Contract
Signup and view all the flashcards
Contract maximizing agent's utility
Contract maximizing agent's utility
Signup and view all the flashcards
Output with Uncertainty
Output with Uncertainty
Signup and view all the flashcards
State-contingent contracts
State-contingent contracts
Signup and view all the flashcards
Profit-max state-contingent contract
Profit-max state-contingent contract
Signup and view all the flashcards
Stabilizing agents
Stabilizing agents
Signup and view all the flashcards
Optimal contracts
Optimal contracts
Signup and view all the flashcards
Study Notes
Efficiency and Distribution
- Economically efficient contracts maximize the total of the principal's profits and the agent's utility.
W = II + Urepresents this sum.- W can also be referred to as social welfare, social surplus, or the 'size of the pie'.
- Finding the economically efficient contract is expressed as
W = (Q – Y) + (Y − V(E)), which simplifies toW = Q-V(E). - Social surplus equals the total production (Q) minus the cost of producing it (V(E)).
Optimal Contracts
- The optimal contract has a 100% commission rate regardless of whose welfare is being maximized.
- Maximising the size of the pie should be prioritised.
- Maximising the pie is done by setting
b = 1.
Problems for Economically Efficient Contracts
- Problem 1 requires finding an economically efficient contract by choosing b to maximize the sum of II + U, subject to the constraint E* = b.
- The economically efficient contract maximizes the sum of the principal’s profits plus the agent’s utility and has a 100% commission rate (b = 1).
- Problem 2 finds the contract (a, b) that maximizes the agent's utility, subject to the incentive-compatibility constraint (E* = b) and a participation constraint for the principal.
- The outcome of this problem is also b = 1.
Uncertainty and Risk Aversion
- Introducing uncertainty means the output equation becomes: Q = dE + ε, where ε is a random variable with a mean of zero.
- The variable ε's realization represents the "state of nature".
- Setting b=1 in uncertain conditions exposes the worker to high risk.
- Firms that are risk neutral may find it socially optimal and profitable to provide workers with insurance against uncertainty in production.
- This insurance can include a lower piece rate combined with a higher base pay.
- There can be two possible states of nature: a 'good' state with ε = εg and a 'bad' state with ε = εb < εg.
- Output is given as:
Q = dE + ɛgin good times andQ = dE + ɛbin bad times.
State Contingent Contracts
- Firms and workers can write/enforce employment contracts that depend on the state of nature, known as state-contingent contracts.
- These contracts stipulate different "a" and "b" values based on the state of nature.
- Contracts now consist of two ordered pairs: (ab, bb) for bad times and (ag, bg) for good times.
- State-contingent contracts can vary by intercept and slope depending on the state of nature.
- The profit-maximizing state-contingent contract for risk-averse workers, firms that are risk neutral maximizes profit sets b=1 in all states but insures workers by offering a higher intercept (a) in worse states of nature.
Formalization of the Best Contract
- The most effective contract formally has bb = bg = 1 and ab > ag.
- The best state-contingent contract stabilises agents' take-home pay by giving a higher pay intercept during bad times.
- This insurance is provided through the intercept (a) of the contract, maintaining 100% marginal incentives by keeping the contract's slope at b=1 in both good and bad times.
- Optimal state-contingent contracts can be implemented without requiring workers to pay for their jobs by providing a fixed "draw" (D) in both good and bad times.
- Sales targets can be raised in good times relative to bad times.
- Firms can insure workers without compromising incentives by reducing the standard workers meet to qualify for incentive pay during bad times.
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
