The Econometric Analysis of the Principal -Agent Problem Using a Contemporary Employment Contract as a Model

Abstract

This essay investigates the theory behind principal-agent problems by utilizing mathematical tools and contractual policies for the offered analysis. With a reliance on Boolean Search technique, the essay’s study design follows narrative literature reviews. The overall effort has been answering several study questions, which included the following: (a) does the type of contract matter to the two parties—the principal and the agent? (b) what informs the determination of fixed wage? and (c) how does the risk types among the agent and principal influence the type of contract? Also, as a part of the study findings: it has been concluded that the type of prevailing contract or offer matters to both the agent and the principal. A crucial factor of the study is the revealed that fixed wage determination should be tied to the agent’s reservation utility and the type of effort embarked on. With regard to the effect of the type of prevailing risk on the offer, it is concluded in the essay that once effort is observable and the agent is risk averse, then such agent has to be insured. The rationale behind the foregoing scenario is the fact that risk sharing becomes possible if the principal is risk neutral. Meanwhile, efficiency demands that it is advisable for the principal to insure the agents, who is risk averse, by offering a wage that does not depend on the variability of profit. The research for the study has revealed further that, in instances whereby both the principal and the agent are risk neutral, then there are several kinds of options made available to the agent, which include (a) fixed wage, and (b) tying wages to efforts when efforts are observable. Also, for the situation whereby a pursued effort is not observable while the agent is risk averse, then the principal has to provide a variety of incentive schemes or structure in the context of the agents for him/her to improve upon his/her utility, thereby either choosing or putting in the right effort. Finally, in a case whereby the requisite effort is not observable and agent is risk neutral, it is advisable that the principal should, in principle, sell the project to the agent for a fixed income (F). Thus, if the agent is risk neutral, then one should allow the agent to face the risk and subsequently for one to choose the optimal effort to maximize the ultimate or expected utility.

Keywords: Principal, Utility, Firm, Risk, Business, Agent, Moral-Hazard, Maximize, Asymmetric-Information, Hires, Incentives, Insurance.

DOI: 10.7176/MTM/12-1-03

Publication date: January 31^st 2022