SYLLABUS OF THE COURSE
Course name: Economics of Contracts
Faculty: Economics
Level of education: Bachelor’s (senior undergraduates)
ECTS credits: 6 credits
Аuthor: Skorobogatov A. S., candidate of economics, professor
Instructor: Skorobogatov A. S., candidate of economics, professor
Program outline
1. Prerequisites: Calculus, Intermediate Microeconomics, Game Theory
Course overview:
The course focuses on the microeconomic issues of asymmetric information such as adverse selection, moral hazard, and incomplete contracting. The general models as well as their managerial and organizational implications are to be considered. The course consists in the three parts.
The first part considers the topics of pre-contract opportunism, related with the adverse selection. They include the general model; the lemon market model in the alternative versions; models of labor, insurance, and credit contracts; the general model of screening and the models of insurance and labor market; the general model of signaling, and the models of education, price and advertising competition.
In the second part the issues of moral hazard are to be considered: the general model and its managerial implications; the organizational means to deal with the problem of the hidden actions such as profit sharing and effective wage; moral hazard in team and its models proposed by Alchian and Holmstrom.
The third part addresses the issues of incomplete contracting arising from the gaps in planning which are consciously admitted in a contract. As a result the optimizing behavior of parties to an incomplete contract is a more complicating comparing with that analyzed in the traditional contract theory. The foundations of incomplete contract economics were laid in the works Ronald Coase and Oliver Williamson whose approach is often labeled as transaction costs economics. Formalization of their approach has resulted in the models of incomplete contracts.
Among the models which are to be considered will be the following: Williamson’s hostage model which analyzes the tensions in relations of parties to a contract arising from the transaction-specific investments; Hart-Moore model analyzing relationship between incompleteness of contracts and levels of specific investments made by the parties with the conclusion that the incomplete contracts cause to underinvestment comparing the optimal values; Grossman-Hart model containing the most general formal description of relationship between property rights distribution and effective values of the transaction-specific investments; Tirole-Furubotn-Richter model as an adaptation of the previous model to relations of a buyer and a seller; option contracts model describing how to solve the problem of the underinvestment by means of the options; the models of reputation and relational contracting which demonstrate organizational potential of the reputation and personified trading relations as a means to deal with the issues of the contract incompleteness.
The course has some elements of originality which can be presented as follows. As a principle of the composition of the course the several stages of a transaction are taken, and so the partition the course into the sections accords to the stages of a transaction. Each stage is considered as a problem and its solution. It gives an opportunity to properly to classify the main subject areas and concepts of the contract economics. The detailed examination of the important models is proposed such as the original model of Akerlof, and Hart-Moore and Grossman-Hart models which previously were not included in any courses in Russian universities. Analytical tasks and numerical exercises are proposed to help the students to use the models for analysis of the real managerial issues. The course is designed to develop students’ investigative skills.
2. Goals, benefits, learning outcomes:
Goals:
- to introduce basic foundations of the contemporary theory of asymmetric information;
- to highlight features of the contract theory as a research framework;
- to get students familiar with the current state of affairs in the field;
- to help students to prepare some brief research project in the area covered by the contract theory.
Benefits:
Economics of contracts is a powerful set of research tools which may be indispensable facing a wide range of issues related to social interactions.
Learning outcomes:
When having finished the course students are to be able to:
- distinguish between various types of asymmetric information;
- explain the sources of those types;
- explain link between the contract economics and standard microeconomics with respect to their assumptions and implications;
- use main models in the field for explaining typical pattern of rational behavior in various areas of social life.
.
3. Distribution of hours
Topics / Class hours / Self-studyLectures / Seminars
1. / Introduction in contract economics: the main concepts and subject areas / 2 / 6
2. / Pre-contract opportunism: statement of an issue / 2 / 2 / 6
3. / Generalized model of pre-contract opportunism and screening for zero bargaining capacity of an agent / 2 / 2 / 20
4. / Solution of the issue of pre-contract opportunism: screening in the condition of the absolute bargaining capacity of agents / 2 / 2 / 10
5. / Solution of an issue of pre-contract opportunism: signaling / 2 / 2 / 10
6. / Post-contract opportunism: statement of an issue and its solutions / 2 / 2 / 10
7. / Solution of an issue of post-contract opportunism: profit sharing / 1 / 2 / 10
8. / Solution of an issue of post-contract opportunism: moral hazard in team and effective wage / 1 / 2 / 6
9. / Organizational arrangements for various transactions / 2 / 2 / 10
10. / Incompleteness of contracts: statement of an issue / 2 / 2 / 10
11. / Solution of an issue of contract incompleteness: effective distribution of property rights / 2 / 2 / 10
Total / 20 / 20 / 108
4. Course content
Lecture 1. Introduction in contract economics: the main concepts and subject areas
In the first lecture the general scheme of contract economics is presented. The kinds of the informational asymmetry are defined and explained, such as hidden information, hidden action, and King Solomon’s problem. Their economic consequences — adverse selection, moral hazard and moral hazard in team are analyzed. The criteria for distinction between principal and agent are described, namely, the informational endowment and the attitude to risk. The relationship between the hidden information and adverse selection and between the hidden action and moral hazard are considered. There are analyzed differences in the attitude to risk as a condition of the second-best in the adverse selection models, and as a condition of moral hazard.
Section I. Ex ante contract process and pre-contract opportunism
Lecture 2. Pre-contract opportunism: statement of an issue
The adverse selection is described as an element of ex ante contract process. The model of second-hand cars is presented in the original form in which it was first proposed by Akerlof and in the standard form as it is set forth in textbooks with comparing the two forms by their assumptions and conclusions. The market destruction and the exclusion of the best from the market as the two possible effects of the hidden information are presented. The adverse selection in various areas of economic and social activity is considered, namely, in labor market, banking, insurance, politics, introduction service market, etc. The analytical tools which described in the lecture are to be applied to analysis of the real issues which a student may face with.
Lecture 3. Generalized model of pre-contract opportunism and screening for zero bargaining capacity of an agent
There presented a model with the two kinds of agents indistinguishable for a principal, but with whom he is to contract differently because of difference between the agents in their attitude to a good proposed them by the principal. Their relations are considered in conditions of symmetry and asymmetry of information about the agent kind. The optimal menu of contracts is presented as a solution of the problem for the principal arising from hidden information. This model is generalized for discrete and continuous utility functions of an agent by his kind. The main features of an optimal contract in the generalized models of adverse selection are described, and there are made the proper organizational implications.
Lecture 4. Solution of the issue of pre-contract opportunism: screening in the condition of the absolute bargaining capacity of agents
Significance of an assumption concerning distribution of bargaining capacity between a principal and an agent in the models of pre-contract opportunism is shown. Difference between monopoly of a principal and Bertrand competition of principals for agents is described from the point of view of the incentives of the agents to reveal information about their kind. The generalized model of screening in the condition of Bertrand competition of principals is presented. The key assumptions and their analytical effect are described. The pooling and separating equilibria are considered. The pooling equilibrium is analyzed as a special case of Nash non-equilibrium. The instances of screening in labor market are considered.
Lecture 5. Solution of an issue of pre-contract opportunism: signaling
An assumption of non-zero bargaining capacity of an agent as a prerequisite of positive incentives of an agent to signalize about his kind is presented and explained. The generalized model of signaling is presented. There described the special features of the pooling and separating equilibria and their connection with the model assumptions. The Cho-Kreps intuitive criterion for selection of equilibrium is presented. The instances of signaling in labor market and consumer market are given. There is described a model of education as a means for signaling about an agent’s kind. The research agenda is proposed for studying educational strategies and signaling considerations as their part in our university.
Section II. Ex ante contract process and post-contract opportunism
Lecture 6. Post-contract opportunism: statement of an issue and its solutions
The content of a contract between principal and agent making the conditions for moral hazard is described. The simple model with the two levels of agent’s efforts and the two levels of principal’s results is presented. The general problem of stimulating agent’s efforts which are unwatchable but have a strong effect on a principal’s utility (profit) is considered and applied for analysis of some today issues. The fundamental conflict between incentives and insurance as a key source of moral hazard is defined and explained. Moral hazard in various areas of economic activity such as insurance, financial markets, governmental counter-cyclical policy, and labor market is considered. Macroeconomic implications of moral hazard, namely, the Minsky paradox are analyzed.
Lecture 7. Solution of an issue of post-contract opportunism: profit sharing
Distribution of bargaining capacity between principal and agent is considered as a prerequisite determining implementation of a profit sharing arrangement. Optimal contracts are considered in case of an absolute bargaining capacity of an agent for symmetric information as well as for asymmetric one. The conflict between the agent‘s incentives and insurance is considered by the example of the model. Optimal contracts are considered in case of zero bargaining capacity of an agent for symmetric information as well as for asymmetric one. The conflict between the agent‘s incentives and insurance is considered by the example of the model. The net loss of a principal is considered as a result of transfer of his trading gain to agent due to hidden action.
Lecture 8. Solution of an issue of post-contract opportunism: moral hazard in team and effective wage
Impossibility of implementation of a profit sharing in case of relation of principal and a group of agents is to be proven. An assumption on the clear for a principal and an agent relationship between the latter’s efforts and the former’s expected gain is set forth and explained. Alternative arrangements for solving an issue of moral hazard are considered such as a checking organization for the case of indistinguishibility of labor contribution of an agent into a collective work; 100% reward; competition; and effective wage. Macroeconomic consequences of effective wage and their relationship with the microeconomic foundations for its implementation are analyzed. There are shown organizational and policy implications of the models considered.
Section III. Ex post contract process: an issue of contract realization
Lecture 9. Organizational arrangements for various transactions
The parameters of transactions, namely relational specificity of assets, structural uncertainty and transaction frequency, are considered and their significance for theory of organization as well. The legal classification of contracts with the three kinds – classical, neoclassical and relational – is described. There are considered various means of management, namely market, trilateral, bilateral and unilateral ones. Trade-off between market and hierarchy with the alternatives as market, hierarchy and hybrid is analyzed. Effective organization of transactions is described as a result of its conformity to the parameters of a transaction. There are given some conformities such as market and classical contract, hybrid and neoclassical contract, firm and relational contract.
Lecture 10. Incompleteness of contracts: statement of an issue
There are explained assumptions of a theory of incomplete contracts as for rationality and kind of informational asymmetry, property rights, firm and integration. The assumptions are compared with those of transaction costs economics. The Hart-Moore model is presented and explained. There are described relationships between contract incompleteness and underinvestment. Transaction-specific investment is related with issue of positive externalities. The Hart-Moore model’s assumptions are explained as implying underinvestment. Possibilities of relaxing the model’s assumptions are discussed, such as renegotiation and option contracts. The analytical tasks and managerial implications of the presented model are discussed.
Lecture 11. Solution of an issue of contract incompleteness: effective distribution of property rights
The Grossman-Hart model is presented and explained. Complete contract, non-integration, control of a firm over actions of both firms, and optimal distribution of property rights are discussed as elements of the model. The Tirole-Furubotn-Richter model is presented and explained. Non-integration and control of a buyer and control of a seller are discussed as elements of the model. Implications of the models are discussed for distribution of the assignments inside an organization. The analytical tasks and managerial implications of the presented model are discussed. Differences between assumptions of transaction costs economics and the Grossman-Hart model are discussed which result in different understandings of optimal size of firm.