Contract Theory -F-M

Contract Theory would be boring, if both the principal and the agent have identical information about all relevant aspects in their relationship: The optimal contract design by the principal in this situation would be simple - "If you do the task as I would do, I pay you a reward, otherwise you get nothing" - and the principal would perfectly control the agent and induce his actions to be what she would like to do herself. So Contract Theory is only interesting, if the agent has some kind of private information. This private information can be of two types and, therefore, induce two different contractual problems:

• Adverse selection: In some situations, the agent is better informed than the principal about his personal characteristics e.g. his abilities or valuations. These situations are called principal-agent relationships with hidden characteristics and the resulting problem for the principal is called adverse selection. Such a problem might occur, for example, in a situation in which an entrepreneur needs outside financing to undertake a new project. If lenders cannot directly tell whether the project is good or bad, an interest rate tailored to an average project quality tends to attract only an entrepreneur with a bad project because he is more likely to default on his loan and is therefore less affected by an entrepreneur of a good project. But this selection would be adverse to lenders’ interests.
• Moral hazard: In other situations, the agent can take an action unobserved by the principal or he receives information during the project not known by the principal. These situations are called principal-agent relationships with hidden action, respectively hidden knowledge, and the resulting problem for the principal is called moral hazard. In the example above, suppose the project’s success depends on whether the entrepreneur’s cash is invested in the project or used for consumption. If lenders cannot verify this decision, the entrepreneur might have an incentive to misbehave when the private benefits from consumption exceeds the reduced success probability of the project. In this case, a lender will not

Given these two principle contractual problems, we discuss the following four classes of principal-agent relationships in our course: Adverse selection and Screening where the uninformed principal offers a contract; Adverse Selection and Signaling where the informed agent signals his private information before the principal offers the contract; Moral hazard and Single Agency where the principal contracts with only one agent; and Moral hazard and Multi Agency where the principal contracts with a group of interacting agents.

By the end of the course, students will advance their knowledge in different ways:

• Learning the concepts of contract theory will help you to understand the basic drivers of interactive behaviour and be helpful for your master thesis in corporate finance
• Learning to create value through team work will be useful for other group works and cases
• Learning to apply contract theoretical basics to practical economic issues and real-world scenarios will improve your critical thinking in other courses
• Learning to structure a problem in own words, but also using mathematics will be useful for your university and business career
• Asking the right questions or detecting inconsistencies in discussions improves your communication skills

Bolton, Dewatripont: Contract Theory, MIT 2005 Laffont, Martimort: The theory of incentives: Princeton 2009

Lecture

Assignments

Presentation

Group assignments: 50%

Individual assignments: 30%

Presentation of individual and group assignments: 20%

Enrolling in this course requires (informal) prerequisites:

150