Huihua NIE_Contract Theory 1. Introduction Overview Walras(1954): contracts curve in Edgeworth box Arrow-Debreu (1972/1983 Nobel prize): contingent contracts Williamson (2009 Nobel Akerlof, Spence, Stiglitz prize), Hart: (?) (2001 Nobel prize): moral Incomplete contract theory hazard, adverse selection Hurwicz, Maskin, Myerson (2007 Nobel prize): mechanism design Vickrey, Mirrlees (1996 Nobel prize): asymmetric information in policy making 1
Huihua NIE_Contract Theory Framework Definitions Principal: contractee/leader/master. Agent: contractor/follower/mastered. Contract: any voluntary agreements between agents, legal or illegal, explicit or implicit, long or short, formal or informal. Asymmetric information: the information which at least one agent doesn’t know, including imperfect information and incomplete information Moral hazard: unobservable endogenous variables; hidden actions. Adverse selection: unobservable exogenous variables; hidden information. [Note 1] Some textbook calls the informed party the agent, and the uninformed party the principal. It is wrong for sometimes the principal has advantage of information. [Note 2] Sometimes moral hazard happens with hidden information. Assumptions (1) There are conflicting interests and almost informational asymmetry between the principals and the agents. The factor that conflicting interests is fundamental, while there also interest conflict when the information is symmetric. (2) The principal often has all the bargaining power and designs the contract offered to the agent, the agent “take it or leave it”. The assumption greatly reduces analysis, and avoids the problem of multi-equilibria. However, we will release it in incomplete contracting setting. (3) Contracts only conclude verifiable terms. (4) The object of contractual design is to maximize the principal’s utility subjected to the agent’s individual constraint and incentive constraint conditions. The agent’s individual constraint stands for his preserve utility which indicates market competition. Mathematically, to transpose the positions of the principal and the agent, the result will hold according to dual programming. (5) Contract theory deals with partial equilibrium, and sometimes deals with related markets. Framework Static bilateral: single task/multi-task Moral hazard Static multilateral: team production Repeated bilateral: reputation Complete contract Static bilateral: screen/signaling Adverse selection Static multilateral: auction/collusion Contract Repeated bilateral: renegotiation Transaction cost economics Incomplete contract Property-rights theory/the theory of the firm Relational contract (dynamics) Models 2
Huihua NIE_Contract Theory The main approach is game theory. The basic models are moral hazard and adverse selection, and hold-up for complete contracting theory and incomplete contracting theory, respectively. We can summarize ten main static models as follows: (1) Moral hazard with hidden action t=0 t=1 t=2 t=3 t=4 time P design A accepts A offers N decidescontract contract or rejects efforts state implements Fig. 1-1 [Note 1] It’s the simplest moral hazard model. If there is no uncertain or nature’s action, there is no moral hazard. Why? (2) Moral hazard with hidden information t=0 t=1 t=2 t=3 t=4 time P design A accepts N decidesA offers contract contract or rejects state efforts implements Fig. 1-2 [Note 2] Only can the agent see the state of the nature. (3) Ex ante adverse selection t=0 t=1 t=2 t=3 time N decides P design A acceptscontract state contract or rejectsimplements Fig. 1-3 [Note 3] It’s the simplest adverse selection model, such as “lemon market”, and sometimes the model is named as “screening model”. (4) Interim adverse selection t=0 t=1 t=2 t=3 time P design A accepts N decidescontract contract or rejects state implements 3
Huihua NIE_Contract Theory Fig. 1-4 [Note 4] Actually it’s adverse selection with bilateral asymmetric information. (5) Signaling I t=0 t=1 t=2 t=3 t=4 time N decides A P design A acceptscontract state signals contract or rejectsimplements Fig. 1-5 (6) Signaling II t=0 t=1 t=2 t=3 time N decides P design contract A acceptscontract state for P and signals or rejectsimplements Fig. 1-6 [Note 5] Where now the principal has private information. Of course the model looks like the former model when we transpose the positions of the principal and the agent. (7) Screening t=0 t=1 t=2 t=3 time N decides P design A acceptscontract state contract or rejectsimplements Fig. 1-7 [Note 6] Some economist (. Rasemusen) thought there is no difference between signaling and screening; however interestingly BD thought there is no difference between adverse selection and screening. (8) Adverse selection before moral hazard t=0 t=1 t=2 t=3 t=4 t=5 time N decides P design A acceptsA offers N effects contract state contract or rejectsefforts outcome implements Fig. 1-8 4
Huihua NIE_Contract Theory (9) Moral hazard before adverse selection t=0 t=1 t=2 t=3 t=4 time P design A accepts A offers N decidescontract contract or rejects efforts state implements Fig. 1-9 (10) Holdup t=0 t=1 t=2 t=3 t=4 t=5 time P design A accepts A makes N decidesparties contract contract or rejects investmentstate renegotiate implements Fig. 1-10 5
