The Theory of Incentives
The Principal-Agent Model
1st Edition
Published on 18. November 2019
440 pages
978-1-4008-2945-3 (ISBN)
Description
Economics has much to do with incentives--not least, incentives to work hard, to produce quality products, to study, to invest, and to save. Although Adam Smith amply confirmed this more than two hundred years ago in his analysis of sharecropping contracts, only in recent decades has a theory begun to emerge to place the topic at the heart of economic thinking. In this book, Jean-Jacques Laffont and David Martimort present the most thorough yet accessible introduction to incentives theory to date. Central to this theory is a simple question as pivotal to modern-day management as it is to economics research: What makes people act in a particular way in an economic or business situation? In seeking an answer, the authors provide the methodological tools to design institutions that can ensure good incentives for economic agents.
This book focuses on the principal-agent model, the "simple" situation where a principal, or company, delegates a task to a single agent through a contract--the essence of management and contract theory. How does the owner or manager of a firm align the objectives of its various members to maximize profits? Following a brief historical overview showing how the problem of incentives has come to the fore in the past two centuries, the authors devote the bulk of their work to exploring principal-agent models and various extensions thereof in light of three types of information problems: adverse selection, moral hazard, and non-verifiability. Offering an unprecedented look at a subject vital to industrial organization, labor economics, and behavioral economics, this book is set to become the definitive resource for students, researchers, and others who might find themselves pondering what contracts, and the incentives they embody, are really all about.
This book focuses on the principal-agent model, the "simple" situation where a principal, or company, delegates a task to a single agent through a contract--the essence of management and contract theory. How does the owner or manager of a firm align the objectives of its various members to maximize profits? Following a brief historical overview showing how the problem of incentives has come to the fore in the past two centuries, the authors devote the bulk of their work to exploring principal-agent models and various extensions thereof in light of three types of information problems: adverse selection, moral hazard, and non-verifiability. Offering an unprecedented look at a subject vital to industrial organization, labor economics, and behavioral economics, this book is set to become the definitive resource for students, researchers, and others who might find themselves pondering what contracts, and the incentives they embody, are really all about.
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Persons
Jean-Jacques Laffont is Professor of Economics and Director of the Institut d'Economie Industrielle (IDEI) at the University of Social Sciences in Toulouse, one of Europe's leading centers for the study of economics. He has won a number of prestigious awards for his research and is a former President of the European Economic Association and of the Econometric Society. His books include The Economics of Uncertainty and Information, Fundamentals of Public Economics, Incentives and Political Economy, and he is the coauthor of Incentives in Public Decision Making, A Theory of Incentives in Procurement and Regulation, and Competition in Telecommunications. David Martimort is Professor of Economics and a research fellow of the IDEI at the University of Social Sciences in Toulouse. He has been a visiting professor at Harvard, MIT, Pompeu Fabra in Barcelona, ECARE in Brussels, and is a member of the Center for Economic and Policy Research in the United Kingdom. He is Associate Editor of the Rand Journal of Economics.
Content
xi Foreword
Introduction 1
1 Incentives in Economic Thought 7
1.1 Adam Smith and Incentive Contracts in Agriculture 8
1.2 Chester Barnard and Incentives in Management 11
1.3 Hume, Wicksell, Groves: The Free-Rider Problem 14
1.4 Borda, Bowen, Vickrey: Incentives in Voting 15
1.5 Leon Walras and the Regulation of Natural Monopolies 18
1.6 Knight, Arrow, Pauly: Incentives in Insurance 18
1.7 Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives 20
1.8 Dupuit, Edgeworth, Pigou: Price Discrimination 22
1.9 Incentives in Planned Economies 23
1.10 Leonid Hurwicz and Mechanism Design 25
1.11 Auctions 27
2 The Rent Extraction-Efficiency Trade-Off 28
2.1 The Basic Model 32
2.2 The Complete Information Optimal Contract 33
2.3 Incentive Feasible Menu of Contracts 36
2.4 Information Rents 39
2.5 The Optimization Program of the Principal 40
2.6 The Rent Extraction-Efficiency Trade-Off 41
2.7 The Theory of the Firm Under Asymmetric Information 46
2.8 Asymmetric Information and Marginal Cost Pricing 48
2.9 The Revelation Principle 48
2.10 A More General Utility Function for the Agent 51
2.11 Ex Ante versus Ex Post Participation Constraints 57
2.12 Commitment 63
2.13 Stochastic Mechanisms 65
2.14 Informative Signals to Improve Contracting 68
2.15 Contract Theory at Work 72
Appendix 81
3 Incentive and Participation Constraints with Adverse Selection 82
3.1 More than Two Types 86
3.2 Multidimensional Asymmetric Information 93
3.3 Type-Dependent Participation Constraint and Countervailing Incentives 101
3.4 Random Participation Constraint 115
3.5 Limited Liability 118
3.6 Audit Mechanisms and Costly State Verification 121
3.7 Redistributive Concerns and the Efficiency-Equity Trade-Off
134 Appendices 130
4 Moral Hazard: The Basic Trade-Offs 145
4.1 The Model 148
4.2 Risk Neutrality and First-Best Implementation 153
4.3 The Trade-Off Between Limited Liability Rent Extraction and Efficiency 155
4.4 The Trade-Off Between Insurance and Efficiency 158
4.5 More than Two Levels of Performance 163
4.6 Informative Signals to Improve Contracting 167
4.7 Moral Hazard and the Theory of the Firm 172
4.8 Contract Theory at Work 174
4.9 Commitment Under Moral Hazard 184
Appendices 185
5 Incentive and Participation Constraints with Moral Hazard 187
5.1 More than Two Levels of Effort 191
5.2 The Multitask Incentive Problem 203
5.3 Nonseparability of the Utility Function 226
5.4 Redistribution and Moral Hazard 232
Appendices 235
6 Nonverifiability 260
6.1 No Contract at Date 0 and Ex Post Bargaining 242
6.2 Incentive Compatible Contract 244
6.3 Nash Implementation 246
6.4 Subgame-Perfect Implementation 256
6.5 Risk Aversion 261
6.6 Concluding Remarks 264
7 Mixed Models 265
7.1 Adverse Selection Followed by Moral Hazard 269
7.2 Moral Hazard Followed by Adverse Selection 294
7.3 Moral Hazard Followed by Nonverifiability 298
8 Dynamics Under Full Commitment 303
8.1 Repeated Adverse Selection 307
8.2 Repeated Moral Hazard 319
8.3 Constraints on Transfers: The Role of Implicit Incentives 342
9 Limits and Extensions 347
9.1 Informed Principal 351
9.2 Limits to Enforcement 360
9.3 Dynamics and Limited Commitment 364
9.4 The Hold-Up Problem 370
9.5 Limits to the Complexity of Contracts 375
9.6 Limits in the Action Space 387
9.7 Limits to Rational Behavior 391
9.8 Endogenous Information Structures 395
References 399
Author Index 413
Subject Index 417
Introduction 1
1 Incentives in Economic Thought 7
1.1 Adam Smith and Incentive Contracts in Agriculture 8
1.2 Chester Barnard and Incentives in Management 11
1.3 Hume, Wicksell, Groves: The Free-Rider Problem 14
1.4 Borda, Bowen, Vickrey: Incentives in Voting 15
1.5 Leon Walras and the Regulation of Natural Monopolies 18
1.6 Knight, Arrow, Pauly: Incentives in Insurance 18
1.7 Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives 20
1.8 Dupuit, Edgeworth, Pigou: Price Discrimination 22
1.9 Incentives in Planned Economies 23
1.10 Leonid Hurwicz and Mechanism Design 25
1.11 Auctions 27
2 The Rent Extraction-Efficiency Trade-Off 28
2.1 The Basic Model 32
2.2 The Complete Information Optimal Contract 33
2.3 Incentive Feasible Menu of Contracts 36
2.4 Information Rents 39
2.5 The Optimization Program of the Principal 40
2.6 The Rent Extraction-Efficiency Trade-Off 41
2.7 The Theory of the Firm Under Asymmetric Information 46
2.8 Asymmetric Information and Marginal Cost Pricing 48
2.9 The Revelation Principle 48
2.10 A More General Utility Function for the Agent 51
2.11 Ex Ante versus Ex Post Participation Constraints 57
2.12 Commitment 63
2.13 Stochastic Mechanisms 65
2.14 Informative Signals to Improve Contracting 68
2.15 Contract Theory at Work 72
Appendix 81
3 Incentive and Participation Constraints with Adverse Selection 82
3.1 More than Two Types 86
3.2 Multidimensional Asymmetric Information 93
3.3 Type-Dependent Participation Constraint and Countervailing Incentives 101
3.4 Random Participation Constraint 115
3.5 Limited Liability 118
3.6 Audit Mechanisms and Costly State Verification 121
3.7 Redistributive Concerns and the Efficiency-Equity Trade-Off
134 Appendices 130
4 Moral Hazard: The Basic Trade-Offs 145
4.1 The Model 148
4.2 Risk Neutrality and First-Best Implementation 153
4.3 The Trade-Off Between Limited Liability Rent Extraction and Efficiency 155
4.4 The Trade-Off Between Insurance and Efficiency 158
4.5 More than Two Levels of Performance 163
4.6 Informative Signals to Improve Contracting 167
4.7 Moral Hazard and the Theory of the Firm 172
4.8 Contract Theory at Work 174
4.9 Commitment Under Moral Hazard 184
Appendices 185
5 Incentive and Participation Constraints with Moral Hazard 187
5.1 More than Two Levels of Effort 191
5.2 The Multitask Incentive Problem 203
5.3 Nonseparability of the Utility Function 226
5.4 Redistribution and Moral Hazard 232
Appendices 235
6 Nonverifiability 260
6.1 No Contract at Date 0 and Ex Post Bargaining 242
6.2 Incentive Compatible Contract 244
6.3 Nash Implementation 246
6.4 Subgame-Perfect Implementation 256
6.5 Risk Aversion 261
6.6 Concluding Remarks 264
7 Mixed Models 265
7.1 Adverse Selection Followed by Moral Hazard 269
7.2 Moral Hazard Followed by Adverse Selection 294
7.3 Moral Hazard Followed by Nonverifiability 298
8 Dynamics Under Full Commitment 303
8.1 Repeated Adverse Selection 307
8.2 Repeated Moral Hazard 319
8.3 Constraints on Transfers: The Role of Implicit Incentives 342
9 Limits and Extensions 347
9.1 Informed Principal 351
9.2 Limits to Enforcement 360
9.3 Dynamics and Limited Commitment 364
9.4 The Hold-Up Problem 370
9.5 Limits to the Complexity of Contracts 375
9.6 Limits in the Action Space 387
9.7 Limits to Rational Behavior 391
9.8 Endogenous Information Structures 395
References 399
Author Index 413
Subject Index 417
