3016:Economics of Information

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3016Economics of Information

• Elements of the Principal Agent model
• Part 3. 10th October

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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

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The PA model

• Relationship between two parts. Bilateral
  relationship
• One party contracts another to carry out some
  type of action or take some decision
• Contractorprincipal
• Contracteeagent
• Shareholder vs. Manager, Shop owner vs. Shop
  assistant
• If they agree, they will sign a contract
• A contract can only contain verifiable variables

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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

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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 assistants
  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

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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