The Theory of Incentives or Economic Approach to Human Behavior

The Theory of Incentives: The Principal-Agent Model

Author: Jean Jacques Laffont

Economics has much to do with incentives--not least, incentives to work hard, to produce quality products, to study, to invest, and to save. Although Adam Smith amply confirmed this more than two hundred years ago in his analysis of sharecropping contracts, only in recent decades has a theory begun to emerge to place the topic at the heart of economic thinking. In this book, Jean-Jacques Laffont and David Martimort present the most thorough yet accessible introduction to incentives theory to date. Central to this theory is a simple question as pivotal to modern-day management as it is to economics research: What makes people act in a particular way in an economic or business situation? In seeking an answer, the authors provide the methodological tools to design institutions that can ensure good incentives for economic agents.

This book focuses on the principal-agent model, the "simple" situation where a principal, or company, delegates a task to a single agent through a contract--the essence of management and contract theory. How does the owner or manager of a firm align the objectives of its various members to maximize profits? Following a brief historical overview showing how the problem of incentives has come to the fore in the past two centuries, the authors devote the bulk of their work to exploring principal-agent models and various extensions thereof in light of three types of information problems: adverse selection, moral hazard, and non-verifiability. Offering an unprecedented look at a subject vital to industrial organization, labor economics, and behavioral economics, this book is set to become the definitive resource for students, researchers, and others whomight find themselves pondering what contracts, and the incentives they embody, are really all about.

Table of Contents:

	Foreword
	Introduction	1
1	Incentives in Economic Thought	7
1.1	Adam Smith and Incentive Contracts in Agriculture	8
1.2	Chester Barnard and Incentives in Management	11
1.3	Hume, Wicksell, Groves: The Free-Rider Problem	14
1.4	Borda, Bowen, Vickrey: Incentives in Voting	15
1.5	Leon Walras and the Regulation of Natural Monopolies	18
1.6	Knight, Arrow, Pauly: Incentives in Insurance	18
1.7	Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives	20
1.8	Dupuit, Edgeworth, Pigou: Price Discrimination	22
1.9	Incentives in Planned Economies	23
1.10	Leonid Hurwicz and Mechanism Design	25
1.11	Auctions	27
2	The Rent Extraction-Efficiency Trade-Off	28
2.1	The Basic Model	32
2.2	The Complete Information Optimal Contract	33
2.3	Incentive Feasible Menu of Contracts	36
2.4	Information Rents	39
2.5	The Optimization Program of the Principal	40
2.6	The Rent Extraction-Efficiency Trade-Off	41
2.7	The Theory of the Firm Under Asymmetric Information	46
2.8	Asymmetric Information and Marginal Cost Pricing	48
2.9	The Revelation Principle	48
2.10	A More General Utility Function for the Agent	51
2.11	Ex Ante versus Ex Post Participation Constraints	57
2.12	Commitment	63
2.13	Stochastic Mechanisms	65
2.14	Informative Signals to Improve Contracting	68
2.15	Contract Theory at Work	72
3	Incentive and Participation Constraints with Adverse Selection	82
3.1	More than Two Types	86
3.2	Multidimensional Asymmetric Information	93
3.3	Type-Dependent Participation Constraint and Countervailing Incentives	101
3.4	Random Participation Constraint	115
3.5	Limited Liability	118
3.6	Audit Mechanisms and Costly State Verification	121
3.7	Redistributive Concerns and the Efficiency-Equity Trade-Off	130
4	Moral Hazard: The Basic Trade-Offs	145
4.1	The Model	148
4.2	Risk Neutrality and First-Best Implementation	153
4.3	The Trade-Off Between Limited Liability Rent Extraction and Efficiency	155
4.4	The Trade-Off Between Insurance and Efficiency	158
4.5	More than Two Levels of Performance	163
4.6	Informative Signals to Improve Contracting	167
4.7	Moral Hazard and the Theory of the Firm	172
4.8	Contract Theory at Work	174
4.9	Commitment Under Moral Hazard	184
5	Incentive and Participation Constraints with Moral Hazard	187
5.1	More than Two Levels of Effort	191
5.2	The Multitask Incentive Problem	203
5.3	Nonseparability of the Utility Function	226
5.4	Redistribution and Moral Hazard	232
6	Nonverifiability	240
6.1	No Contract at Date 0 and Ex Post Bargaining	242
6.2	Incentive Compatible Contract	244
6.3	Nash Implementation	246
6.4	Subgame-Perfect Implementation	256
6.5	Risk Aversion	261
7	Mixed Models	265
7.1	Adverse Selection Followed by Moral Hazard	269
7.2	Moral Hazard Followed by Adverse Selection	294
7.3	Moral Hazard Followed by Nonverifiability	298
8	Dynamics under Full Commitment	303
8.1	Repeated Adverse Selection	307
8.2	Repeated Moral Hazard	319
8.3	Constraints by Transfers: The Role of Implicit Incentives	342
9	Limits and Extensions	347
9.1	Informed Principal	351
9.2	Limits to Enforcement	360
9.3	Dynamics and Limited Commitment	364
9.4	The Hold-Up Problem	370
9.5	Limits to the Complexity of Contracts	375
9.6	Limits in the Action Space	387
9.7	Limits to Rational Behavior	391
9.8	Endogenous Information Structures	395
	References	399
	Author Index	413
	Subject Index	417

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Economic Approach to Human Behavior

Author: Gary Stanley Becker

Since his pioneering application of economic analysis to racial discrimination, Gary S. Becker has shown that an economic approach can provide a unified framework for understanding all human behavior. In a highly readable selection of essays Becker applies this approach to various aspects of human activity, including social interactions; crime and punishment; marriage, fertility, and the family; and "irrational" behavior.
"Becker's highly regarded work in economics is most notable in the imaginative application of 'the economic approach' to a surprising breadth of human activity. Becker's essays over the years have inevitably inspired a surge of research activity in testimony to the richness of his insights into human activities lying 'outside' the traditionally conceived economic markets. Perhaps no economist in our time has contributed more to expanding the area of interest to economists than Becker, and a number of these thought-provoking essays are collected in this book."—Choice
Gary Becker was awarded the Nobel Prize in Economic Science in 1992.