Module XV·Article III·~1 min read
Principal-Agent and Contract Theory
Micro Foundations for Macro and Investment
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Principal-Agent and Contract Theory
Contract theory studies how the design of contracts solves problems of information asymmetry and incentives. It is the micro-foundation for understanding organizations and markets.
Principal-Agent Problem
Essence: the principal hires an agent, but cannot fully observe the agent’s actions or type.
Hidden action (moral hazard): the agent can shirk or take risks.
Hidden information (adverse selection): the agent knows their own type, while the principal does not.
Contract Design
Incentive compatibility: the contract must motivate the agent to act in the principal’s interests.
Participation constraint: the agent must be willing to accept the contract.
Trade-offs:
Risk sharing vs incentives
Rent extraction vs participation
Mechanism Design
Inverse game theory: designing games to achieve the desired outcome.
Revelation principle: any outcome is achievable through a truth-telling mechanism.
Applications: auctions, regulation, matching markets.
For the Investor
Corporate governance: analysis of incentive structures for management.
Compensation design: how compensation influences behavior.
Business model analysis: how companies solve agency problems (platforms, franchises).
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