Industrial Organization III: Contract Theory (EC855

Industrial Organization III: Contract Theory (EC855

Industrial Organization III: Contract Theory

Professor Ingela Alger

Spring 2002(EC855.01)

Economics Department, BostonCollege

Carney 244

tel: (617) 552-1589

e-mail:

Office hours: Wednesdays 12.30-3.30

Description

The main objective of this course is to provide you with the theoretical tools that are commonlyused to analyze situations with asymmetric information. Various applications to IO will becovered throughout the course.

Grading

Course requirements and grading will ultimately depend on the number of students who takethe class (paper presentations will be required if there are few students). However, there willin any case be two exams, which will account for the main part of the grade (60-80%), andproblem sets (20-30%).

Course Material and Outline

Main References

  1. Fudenberg D., J. Tirole. Game Theory.Cambridge: MIT Press, 1991 (FT)
  2. Mas-Colell A., Whinston M.D., J.R. Green. Microeconomic Theory.Oxford: OxfordUniversity Press, 1995 (MWG)
  3. Salanie B. The Economics of Contracts. Cambridge: MIT Press, 1997 (S)

Books applying contract theory to specic topics include:

  1. Laffont J.-J., Tirole J. A Theory of Incentives in Procurement and Regulation. Cambridge: MIT Press, 1993 (LT)
  2. Tirole J. The Theory of Industrial Organization.Cambridge: MIT Press, 1988 (T)
  3. Hart O. Firms, Contracts, and Financial Structure.Oxford: OxfordUniversityPress, 1995 (H)

The following books provide examples that motivate the use of contract theory, and develop

many interesting questions on an intuitive level:

  1. Milgrom P., Roberts J.. Economics, Organization & Management, EnglewoodClis. NJ: Prentice Hall, 1992 (MR)
  2. Williamson O. The Economic Institutions of Capitalism. New York: The FreePress,1985. (W)

Course Outline

* = required reading

I. Introduction

  1. *(S) Chapter 4.1
  2. *(MWG) Chapter 13.A and 13.B
  3. Akerlof G.A. The Market for `Lemons: Quality Uncertainty and the MarketMechanism. Quarterly Journal of Economics, 84: 488-500, 1970.
  4. *(Introduction) Hart O., Holmstrom B. The Theory of Contracts in T. Bewley. ed. Advances in Economic Theory, 5th World Congress of the Econometric Society.Cambridge: Cambridge University Press,1987
  5. *(Introduction and Section 1.1) Laffont J.-J., E. Maskin. The Theory ofIncentives: An Overview in W. Hildenbrand, ed. Advances in Economic Theory, 4thWorld Congress of the Econometric Society. Cambridge: Cambridge University Press,1982

II. Some game theory

  1. Chapter 7 of (MWG) is a good (re-)introduction to game theory.
  2. The concepts that are used in the course are: Nash Equilibrium, Subgame Perfect Equilibrium,
  3. Bayesian Equilibrium, Perfect Bayesian Equilibrium.
  4. These are explained in *(S) Game Theory Appendix.
  5. For further comments, see Section 1.2 in Laffont J.-J., E. Maskin, 1982.
  6. Other sources you may use include: (T) Chapter 11, (MWG) Chapters 7, 8D, 8E, 9.A-9.C and (FT) Chapters 1, 3, 6, 8.1-8.2.

III. Hidden information (Adverse Selection)

A. Introduction

  1. *(S) Chapter 1
  2. *(FT) Introduction to Chapter 7(Sections 1.3 and 2.1) Laffont J.-J., E. Maskin, 1982.

B. The Basic Model (one principal, one agent, full commitment)

  1. *(S) Chapter 2
  2. *(FT) Chapter 7.1-7.3
  3. (MWG) Chapter 14.C
  4. Guesnerie R., Laffont J.-J.A Complete Solution to a Class of Principal-Agent Problems with an Application to the Control of a Self-Managed Firm. Journal of Public Economics, 25:329-369, 1984.

C. Applications

  • Second-Degree Price Discrimination
  1. *(S) Chapter 2.2
  2. *(T) Chapter 3
  3. Maskin E., Riley J. Monopoly with Incomplete Information. RAND Journalof Economics, 15:71-196,1984.
  4. Mussa M., RosenS.Monopoly and Product Quality. Journal of EconomicTheory, 18:301-317, 1978.
  5. Alger I. Consumer Strategies Limiting the Monopolist's Power: Multiple and JointPurchases. RAND Journal of Economics, 30:736-757, 1999.
  6. Stole L.A.Nonlinear Pricing and Oligopoly. Journal of Economics & ManagementStrategy, 4:529-62, 1995.
  • Regulation
  • *(S) Chapter 3.1.1
  • *(LT) Introduction + Chapter 1.1-1.6
  • Baron D.P.,. MyersonR.B. Regulating a Monopolist with UnknownCosts. Econometrica, 50:911-930,1982..
  • Laffont J-.J., Tirole J. Using Cost Observation to Regulate Firms. Journalof Political Economy, 94:614-641, 1986.
  • Auriol E., Laffont J.-J. Regulation by Duopoly. Journal of Economics &Management Strategy, 1:507-533, 1992.
  • Survey: Laffont J-.J. The New Economics of Regulation Ten Years After. Econometrica, 62:507-537,1994.

D. Extensions

  • Multiple Agents: Mechanism Design and Bilateral Trading
  1. *(FT) Chapters 7.4 and 7.5
  2. *(MWG) Chapter 23
  3. Groves T. Incentives in Teams. Econometrica, 41:617-631,1973.
  4. Clarke E. Multipart Pricing of Public Goods. Public Choice, 8:19-33,1971.
  5. D'Aspremont C., Gerard-Varet L.-A.Incentives and Incomplete Information. Journal of Public Economics, 11:25-45,1979
  6. Mookherjee D., ReichelsteinS. Dominant Strategy Implementation ofBayesian Incentive Compatible Allocation Rules. Journal of Economic Theory, 56:378-99, 1992.
  7. Myerson R.B., M. Satterthwaite. Efficient Mechanisms for Bilateral Trading. Journal of Economic Theory, 28:265-281,1983.
  • Application: Auctions
  1. *(S) Chapter 3.2.2
  2. *(LT) Chapters 7.1-7.3
  3. McAfee R.P., McMillanJ.Auctions and Bidding. Journal of EconomicLiterature, 25:699-738,1987
  4. Bulow J., Roberts J.The Simple Economics of Optimal Auctions. Journalof Political Economy, 97:1060-1090,1989
  5. Dasgupta P., Maskin E. Efficient Auctions.Quarterly Journal of Economics,115:341-388,2000
  6. Survey: Klemperer P. Auction Theory: A Guide to the Literature in Dahiya,Shri Bhagwan, ed., The CurrentState of Economic Science, Rohtak, India: Spellbound.1999
  • Multiple Agents: Correlated Types
  1. *(FT) Chapter 7.6.1
  2. *Cremer J., McLean R.P. Optimal Selling Strategies under Uncertainty for aDiscriminating Monopolist when Demands are Interdependent. Econometrica, 53:345-361,1985
  3. Demski J.S., Sappington D.Optimal Incentive Contracts with MultipleAgents. Journal of Economic Theory, 33:152-171,1984.
  4. MooreJ.,Turnbull S. Stopping Agents from `Cheating'.Journal of Economic Theory, 46:355-72,1988
  • Multiple Agents: Collusion
  1. Tirole J.Hierarchies and Bureaucracies: On the Role of Collusion in Organizations. Journal of Law, Economics, and Organizations, 2:181-214, 1986.
  2. Survey: Tirole J.Collusion and the Theory of Organizations in J.-J. Lafont,ed., Advances in Economic Theory: Proceedings of the Sixth World Congress of the Econometric Society. Cambridge; CambridgeUniversity Press.151-206, 1992
  3. Survey: Laffont, J-.J., Rochet J-.C. Collusion in Organizations. Scandinavian Journal of Economics, 99:485-495,1997
  4. Kofman F., Lawarree J. Collusion in Hierarchical Agency. Econometrica,61:629-56,1993
  5. Laffont J-.J., Martimort D. Collusion under Asymmetric Information.Econometrica, 65:875-911,1997
  6. Laffont J-.J., Martimort D. Collusion and Delegation. RAND Journal ofEconomics, 29:280-305,1998
  7. *Laffont J-.J., MartimortD. Mechanism Design with Collusion and Correlation. Econometrica, 68:309-42,2000
  8. Faure-Grimaud A., Laffont J.-J., Martimort D. The Endogenous Transaction Costs of Delegated Auditing. European Economic Review, 43:1039-1048, 1999.
  9. Laffont J.-J. Political Economy, Information and Incentives. European EconomicReview, 43:649-669,1999
  • No Commitment
  1. *(S) Chapter 6 (except 6.5)
  2. *(LT) Chapters 9 and 10
  3. *Bester, H., R. Strausz. Contracting with Imperfect Commitment and theRevelation Principle: The Single Agent Case. Econometrica, 69:1077-98,2001.
  4. Freixas X., Guesnerie R., TiroleJ. Planning under Incomplete Informationand the Ratchet Effect. Review of Economic Studies, 52:173-191,1985.
  5. Dewatripont M. Renegotiation and Information Revelation over Time: The Caseof Optimal Labor Contracts," Quarterly Journal of Economics, 104:589-619,1989.
  • Alternative Participation Constraints
  1. *(S) Chapter 3.1.3. and 3.2.3
  2. *Jullien, B.Participation Constraints in Adverse Selection Models," Journal ofEconomic Theory, 93:1-47,2000
  3. Rochet J.-C., StoleL. Nonlinear Pricing with Random ParticipationConstraints. forthcoming Review of Economic Studies,2000
  • Countervailing Incentives
  1. *(S) Chapter 3.2.7
  2. Lewis T., Sappington D. Countervailing Incentives in Agency Theory. Journal of Economic Theory, 49:294-313, 1989
  • Costly State Veri_cation
  1. Townsend R.Optimal Contracts and Competitive Markets with Costly StateVerification. Journal of Economic Theory, 21:265-293, 1979
  2. Mookherjee D.,PngI.Optimal Auditing, Insurance, and Redistribution.Quarterly Journal of Economics, 104:399-415,1989.
  3. Bolton P., Scharfstein D.S.A Theory of Predation Based on AgencyProblems in Financial Contracting. American Economic Review, 80:93-106, 1990.
  4. Gale D., HellwigM.Incentive-Compatible Debt Contracts: The One-PeriodProblem. Review of Economic Studies, 52:647-663,1985.
  • Endogenous Asymmetric Information; Input v. Output Monitoring
  1. Cremer J., Khalil F.Gathering Information Before Signing a Contract.American Economic Review, 82:567-578, 1992.
  2. Khalil F., Lawarree J.Input versus Output Monitoring: Who Is the ResidualClaimant? Journal of Economic Theory, 66:139-157,1995.
  • Multi-Dimensional Private Information
  1. *(S) Chapter 3.2.4
  2. Survey: Armstrong M., Rochet J-.C. Multi-Dimensional Screening: A User'sGuide. European Economic Review, 43:959-979,1999.
  3. Rochet J.-C., P. Chone . Ironing, Sweeping and Multi-Dimensional Screening.Econometrica, 66:783-826, 1998.
  • Communication Costs and Ethics
  1. *Green J.R., Laffont J.-J.Partially Veriable Information and MechanismDesign. Review of Economic Studies, 53:447-456,1986.
  2. Kofman F., Lawarree J. On the Optimality of Allowing Collusion. Journalof Public Economics, 61:383-407,1996.
  3. Alger I., Renault R. Screening among Agents with Heterogeneous Ethics.Boston College WP 489, 2000.
  4. Alger I., Renault R. Honest Agents and Equilibrium Lies mimeo.BostonCollege and Universite de Cergy-Pontoise,2000.
  5. Alger I., A.C.-t. Ma Moral Hazard, Insurance, and Some Collusion forthcoming Journal of Economic Behavior and Organization, 1998
  6. *Deneckere R, Severinov S. Mechanism Design and CommunicationCosts.mimeoUniversity of Wisconsin, 2001
  7. Lacker J.M., Weinberg J.A.Optimal Contracts under Costly State Falsification. Journal of Political Economy, 97:1345-1363,1989.
  8. Maggi G. and A. Rodriguez-Clare. Costly Distortion of Information in AgencyProblems. Rand Journal of Economics, 26:675-689,1989.
  9. Crocker K.J., Morgan J.Is Honesty the Best Policy? Curtailing InsuranceFraud through Optimal Incentive Contracts. Journal of Political Economy, 106:355-375,1998
  • Informed Principal
  1. *(S) Chapter 3.2.6
  2. *(FT) Chapter 7.6.3
  3. Myerson, R.B.Mechanism Design by an Informed Principal. Econometrica,51:1767-1797,1983
  4. Maskin E., TiroleJ. The Principal-Agent Relationship with an InformedPrincipal: The Case of Private Values. Econometrica, 58:379-409,1990.
  5. Maskin, E., Tirole J. The Principal-Agent Relationship with an InformedPrincipal, II: The Case of Common Values. Econometrica, 60:1-42,1992
  • 12. Multiple Principals
  1. *(FT) Chapter 7.6.5
  2. Epstein L.G., Peters M.A Revelation Principle for Competing Mechanisms.Journal of Economic Theory, 88:119-160, 1999.
  3. *Martimort, D., Stole L. The Revelation and Delegation Principles in Common Agency Games. forthcoming Econometrica,2001
  4. Martimort D. The Multiprincipal Nature of Government. European EconomicReview, 40:673-85,1996.
  5. Martimort D.Exclusive Dealing, Common Agency, and Multiprincipals IncentiveTheory" RAND Journal of Economics, 27:1-31, 1996.

E. Related Topics: Screening on a Competitive Market, and Signaling

  1. *(S) Chapter 3.2.1
  2. *(MWG) Chapter 13.D
  3. Rothschild M., Stiglitz J. Equilibrium in Competitive Insurance Markets:An Essay on the Economics of Imperfect Information. Quarterly Journal of Economics,90:629-649,1976.
  4. Wilson C.A Model of Insurance with Incomplete Information. Journal of Economic Theory, 16:167-207, 1977.
  5. Riley J. Informational Equilibrium. Econometrica, 47:331-359,1979
  6. Survey: Hellwig M.Some Recent Developments in the Theory of Competition inMarkets with Adverse Selection. European Economic Review, 31:319-325, 1987
  7. *(S) Chapter 4
  8. *(MWG) Chapter 13.C
  9. Spence M. Job Market Signaling. Quarterly Journal of Economics, 87:355-374, 1973
  10. Crawford V., Sobel J. Strategic Information Transmission. Econometrica,50:1431-1451,1982

IV. Hidden action (Moral Hazard)

A. Introduction

  1. *(S) Chapter 5.1
  2. (Section 1) Hart O., HolmstromB.,1987

B. The Basic Model (one principal, one agent, commitment)

  1. *(S) Chapters 5.2 through 5.3.4
  2. (MWG) Chapter 14.B
  3. Holmstrom B. Moral Hazard and Observability.Bell Journal of Economics,10:74-91,1979
  4. Shavell S. Risk Sharing and Incentives in the Principal and Agent Relationship. Bell Journal of Economics, 10:55-73,1979
  5. Grossman S.J., Hart O.D. An Analysis of the Principal-Agent Problem. Econometrica, 51:7-45,1983.
  6. Rogerson W. The First-Order Approach to Principal-Agent Problems. Econometrica, 53:1357-1368,1985.

C. Extensions

  • Multiple Agents
  1. *(S) Chapter 5.3.5
  2. *Holmstrom B. Moral Hazard in Teams.Bell Journal of Economics, 13:324-340,1982.
  3. Green J.R., StokeyN.L. A Comparison of Tournaments and Contracts. Journal of Political Economy, 91:349-364,1983.
  4. Mookherjee D. Optimal Incentive Schemes in Multi-Agent Situations. Review ofEconomic Studies, 51:433-446,1984.
  5. Holmstrom B., MilgromP.Regulating Trade Among Agents. Journal ofInstitutional and Theoretical Economics, 146:85-105,1990
  6. Itoh H. Incentives to Help in Multi-Agent Situations. Econometrica, 59:611-636,1991
  7. *Itoh H., Ishiguro S.Moral Hazard and Renegotiation with Multiple Agents. Review of Economic Studies, 68:1-20,2001
  • Multiple Principals
  1. Bernheim B.D., Whinston M.D.Common Agency. Econometrica, 54:923-942, 1986
  • Multitasking
  1. *(S) Chapter 5.3.7
  2. Holmstrom B.,Milgrom P. Multitask Principal-Agent Analyses: IncentiveContracts, Asset Ownership and Job Design. Journal of Law, Economics and Organization, 7:24-51,1991
  • Multiple Periods
  1. *(S) Chapter 6.5
  2. Holmstrom B.,Milgrom P. Aggregation and Linearity in the Provision ofIntertemporal Incentives. Econometrica, 55:303-328,1987
  3. Fudenberg D., Tirole J. Moral Hazard and Renegotiation in Agency Contracts. Econometrica, 58:1279-1320,1990.
  4. Ma, C.-t.A. Adverse Selection in Dynamic Moral Hazard. Quarterly Journal ofEconomics, 106:255-75,1991
  5. Chiappori P.-A., MachoI., ReyP., Salanie B. Repeated Moral Hazard:The Role of Memory, Commitment and the Access to Credit Markets. European EconomicReview, 38:1527-1553,1994
  6. *Matthews S.A. Renegotiating Moral Hazard Contracts under Limited Liabilityand Monotonicity. Journal of Economic Theory, 97:1-29,2001
  • Limited Liability
  1. Sappington D. Limited Liability Contracts between Principal and Agent. Journalof Economic Theory, 29:1-21,1983
  • Models with Moral Hazard and Adverse Selection

1 Myerson R. Optimal Coordination Mechanisms in Generalized Principal-AgentProblems. Journals of Mathematical Economics, 10:67-81,1982.

  1. Guesnerie R., Picard P., Rey P.Adverse Selection and Moral Hazard withRisk Neutral Agents. European Economic Review, 33:807-23,1989

D. Applications

  • Work Incentive Scemes

1 *(S) Chapter 5.4.2

2 Shapiro C., StiglitzJ. Equilibrium Unemployment as a Worker DisciplineDevice. American Economic Review, 74:433-444,1984.

  1. Baker G., Jensen M., Murphy K. Compensation and Incentives: Practicevs. Theory. Journal of Finance, 43:593-616,1988.
  2. Jensen M. ,. MurphyK Performance Pay and Top-Management Incentives.Journal of Political Economy, 98:225-264, 1990
  3. Rosen S. Contracts and the Market for Executives in L. Werin and H. Wijkander,eds., Contract Economics, Oxford: Basil Blackwell,1992
  • Career Concerns
  1. Holmstrom B.Managerial Incentive Problems: A Dynamic Perspective. Reviewof Economic Studies, 66,1999
  2. Dewatripont M., JewittI.,Tirole J. Comparison of Information Structures.The Economics of Career Concerns.Review of Economic Studies, 66:183-198,1999
  3. Dewatripont M., JewittI., Tirole J. Applications to Missions in Organizations. The Economics of Career Concerns. Review of Economic Studies, 66: 199-217,1999
  4. Gibbons R., Murphy K.J. Optimal Incentive Contracts in the Presence ofCareer Concerns: Theory and Evidence. Journal of Political Economy, 100:468-505,1992
  • Insurance
  1. *(S) Chapter 5.4.1
  2. Arrow K.J. Uncertainty and the Welfare Economics of Medical Care. AmericanEconomic Review, 53:941-973,1963
  3. Arrow K.J. Insurance, Risk and Resource Allocation. in K.J. Arrow, ed., Essaysin the Theory of Risk Bearing, Chicago: Markham,1971
  4. Zeckhauser R.Medical Insurance: A Case Study of the Trade-Off Between RiskSpreading and Appropriate Incentives. Journal of Economic Theory, 2:10-26,1970
  5. Ma, C.-t.A., McGuire T.Optimal Health Insurance and Provider Payment.American Economic Review, 87:685-704, 1997
  6. Ma, C.-t.A. Health Care Payment Systems: Cost and Quality Incentives. Journalof Economics & Management Strategy, 3:93-112,1994
  7. McGuire T.Physician Agency in A.J. Culyer and J.P Newhouse, eds., Handbookof Health Economics, Amsterdam: Elsevier Science, 2000
  • Sharecropping
  1. Stiglitz J. Incentives and Risk Sharing in Sharecropping, Review of EconomicStudies, 41:219-256,1974

V. Incomplete contracts

A. Theory

1 *(S) Chapter 7

  1. (H) Chapters 2 and 3
  2. (Section 3) Hart O., HolmstromB.,1987
  3. Grossman S.J., Hart O.D.The Costs and Benefits of Ownership: A Theoryof Vertical and Lateral Integration. Journal of Political Economy, 94:691-719,1986
  4. Hart O., MooreJ. Incomplete Contracts and Renegotiation. Econometrica,56:755-785,1988
  5. Hermalin B.E., Katz M.L. Moral Hazard and Veriability: The Effects ofRenegotiation in Agency. Econometrica, 59:1735-1753,1991
  6. Aghion P., Dewatripont M., ReyP. Renegotiation Design with UnveriableInformation. Econometrica, 62:257-282,1994

B. Foundations and Critique

  1. (H) Chapter 4
  2. Hart O., MooreJ. Foundations of Incomplete Contracts. Review of EconomicStudies, 66:115-138,1999
  3. Maskin E., Tirole J. Unforeseen Contingencies and Incomplete Contracts.Review of Economic Studies, 66:83-114,1999
  4. Anderlini L., Felli L. Incomplete Written Contracts: Undescribable Statesof Nature. Quarterly Journal of Economics, 109:1085-1124,1994
  5. Survey: Tirole J. Incomplete Contracts: Where Do We Stand?. Econometrica,67:741-781,1994
  6. *Bernheim B.D., WhinstonM.D. Incomplete Contracts and Strategic Ambiguity. American Economic Review, 88:902-932,1998

C. Applications: Financial Contracting and the Theory of the Firm

  1. (H) Chapter 1, 5-8
  2. Survey: Holmstrom B., TiroleJ. The Theory of the Firm in R. Schmalenseeand R.D. Willig, eds., Handbook of Industrial Organization, New York: Elsevier SciencePublishers,1989
  3. Aghion P.,BoltonP. An `Incomplete Contracts' Approach to FinancialContracting. Review of Economic Studies, 59:473-494,1992
  4. Hart O., Moore J. A Theory of Debt Based on the Inalienability of HumanCapital. Quarterly Journal of Economics, 109:841-879,1994
  5. Hart O., Moore J. Default and Renegotiation: A Dynamic Model of Debt.Quarterly Journal of Economics, 113:1-41,1998
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