Course Notes

ADVANCED MICROECONOMICS A.S. 2015-2016

Asymmetric information → PRINCIPAL-AGENT problem

P-A problem: generally they have to conclude a deal, but the agent is in the condition that allows him to have more information.

w/this framework:

• Problem 1: HIDDEN ACTION → MORAL HAZARD
• Problem 2: HIDDEN INFORMATION → ADVERSE SELECTION

The principal cannot observe what the agent does (hidden actions). This fact implies that the actions purchased by the agent generate effects upon the principal wealth.

→ In this context, the 2 parties cannot conclude the contract

CONTRACT THEORY: When an action is not observable, it is also not controvertible → The payment is no more a function of the action taken, but on the other hand, a function of the outcome

MORAL HAZARD: When an agent can do what is not in the interest of the principal, but is in the interest of the agent himself.

CONTRACT: Payment = f(outcome) → This kind of adjustment does not come for free

↳ This implies a stochastic process → Also the agent becomes risk-averse hence the agent will bear a loss risk, reducing his utility → AGENCY COST

INSURANCE MARKET:

Insurer → Exp. Π ↓ (PRINCIPAL)

Insured (AGENT) → behaviour →

• not observable
• ↑ Pr. of Accident
• risky → safe

The insurer cannot observe the insured behaviours → Moral Hazard prob

The agent behaves in his interests damaging the insurer → Hidden info.

BONUS/MALUS covenant: is a mean through which the insurance can distinguish btw good and bad agents (drivers)

Price = f(outcome)

• 0 accident
• 1 accident
• 2 accidents
• → when No of acc. ↑ also P ↑
• If the insured want a low P, it should drive safely

Advanced Microeconomics A.S. 2015-2016

Asymmetric information ex principal-agent problem

P-A problem: generally they have to conclude a deal, but the agent is in the condition that allows him to have more information.

• Problem 1: Hidden Action → Moral Hazard
• Problem 2: Hidden Information → Adverse Selection

The principal cannot observe what the agent does. (Hidden actions) This fact implies that the actions purchased by the agent generate effects upon the principal wealth.

→ In this context, the 2 parties cannot conclude the contract

Contract Theory: When an action is not observable, it is also not contractable → The payment is no more a function of the action taken, but on the other hand, a function of the outcome

Moral Hazard: When an agent can do what is not in the interest of the principal, but is in the interest of the agent himself.

Contract: Payment = f(outcome)

This kind of adjustment does not come for free

→ This implies a stochastic process → Also the agent becomes risk-averse, hence the agent will bear a loss risk, reducing its utility → Agency cost

Insurance Market

Insurer → Exp. Π ↓ ↑ Insured →

Principal → Agent → behaviour → Safe

not observable ↑ Pr. of Accident

The insurer cannot observe the insured behaviours → Moral Hazard prob

The agent behaves in his interests damaging the insurer → Hidden Info.

Bonus/Malus covenant: is a means through which the insurance can distinguish btw good and bad agents (drivers)

Price = f(outcome)

• Action 0 accident
• 1 accident
• 2 accidents → when N° of acc. ↑ also P ↑

If the insured want a low P, he should drive safely

RISK-AVERSE agents : want to put all the risk in the insurance comp

vs

RISK-NEUTRAL principal

INCENTIVE COMPATIBLE contract

The agent bears some risk → agent exp. with agency cost

RISK SHARE

The equilibrium contract under hidden info : 2^nd Best Contract

Other examples :

• CREDIT MARKET : Bank (P) lends money to the firm (A) without observing the actions taken by the borrower

Firm₁

More or less risky firm

Firm₂

A Firm's know their behavior

Firm₃

Bank cannot classify all firms

Hence, the bank offers only one price (interest rate)

LR firms will find r too high → do not accept!

HR firms will find r convenient → ACCEPT !

At the end the Bank lends money only to HR firms w/ an higher probability of default → Adverse selection problem.

• Bond-Holder (P) vs Bank (A)
• Professor (P) vs Students (A) → High/low effort

Excess demand situation: D > S → price ↑

In an adv. selection situation a bank will not ↑ r, but will limit the quantity of loan (S) → CREDIT RATIONING of customers (Agency cost)