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The simplest way to work on contract design is to use the principal-agent model.
It is a simple setting representing a contract between two parties
named “The principal” and “The agent”.
The principal is in charge of organizing the activities.
He/she decides the production plan, that is, he decides what is needed to be done.
The agent carries out the activities on behalf of the Principal.
The principal writes the contract.
He/she needs to consider contract design carefully.
He/she wants to maximize his/her own profits,
but he/she needs to worry about the agent’s possible opportunism.
The agent exhibits a selfish behavior, too.
He/she will breach the contract, if it is profitable to do so.
Let’s focus on the principal’s problem now.
The principal is in charge of contract design.
He/she wants to write a contract maximizing his/her own profits.
This means that he/she must worry about two key problems: the size of the coordination surplus
and the share of the surplus he/she can appropriate.
The principal’s gain from the contract is the amount of the coordination surplus multiplied
by the appropriation share.
As we will discuss later, the two variables may be interdependent.
Sometimes the principal must accept a lower coordination surplus
in order to preserve his/her appropriation share.
The principal’s maximization problem is subject to two constraints.
The first one is the Individual Rationality Constraint.
It comes from the free agreement principle.
The agent will not sign a contract that makes him/her worse off.
This means that the agent must obtain at least the same amount of utility or profits that
he/she would obtain from the next best alternative to the contract.
If the agent receives less than this level of utility, the contract is not signed and
the coordination surplus goes to zero.
The second constraint is the Incentive Compatibility Constraint.
The contract must be self-enforcing, leaving no incentive for opportunism.
Opportunism reduces the principal’s appropriation share.
Therefore, the principal has a clear interest in minimizing it.
It turns out that these constraints are very important in contract design.
Now we discuss them in detail.
Let’s focus on the Individual rationality constraint.
The key point of the constraint is that the agent must obtain at least the same utility
as if he/she did not subscribe the contract.
This is an absolute constraint.
If this is not met, there is no contract and no coordination surplus.
Let this segment represent the value of total contract profits.
Ideally, we can break the total value into three parts.
An area that is equal to the agent’s profits from the next best opportunity, such as
the profits that he/she obtains if the contract is not signed (the red area).
This value represents the Agent’s opportunity cost of signing the contract.
The yellow area is equal to the principal’s profits from the next best opportunity,
that is, the principal opportunity cost.
The difference between the total contract value and the sum of the opportunity costs
(the red area plus the yellow area) is the coordination surplus.
Because the agent must receive a return from the contract, at least equal to the opportunity cost,
the principal’s potential profits depend on the size of the coordination surplus.
This is why the principal wants to maximize it.
The maximization of coordination surplus is not a sufficient condition
for the maximization of the principal’s profits.
The distribution of the surplus is a key issue, too.
Remembering the Coase Theorem from Lesson 1 of this module, we can say that in general,
both parties agree to the maximization of the coordination surplus.
Problems arise when the surplus is distributed between the two parties.
Obviously, both parties would like to have a large share of the surplus.
The principal can obtain it with contract design.
The agent can increase the appropriation share with opportunism.
Therefore, the principal wants to prevent the agent’s opportunistic behavior
in order to to increase the share of coordination surplus he/she can appropriate of.
This point introduces us to the second constraint:
the Incentive compatibility constraint.
There are two ways of preventing opportunism: perfect monitoring and enforcement or incentives.
Perfect monitoring means that opportunistic behavior is immediately detected.
Perfect enforcement means that detected opportunistic behavior can be immediately corrected,
without any loss for the principal.
This ideal condition is rare in real life.
If you are lucky enough to benefit from perfect monitoring and enforcement,
you do not need an economist.
You just need to keep your eyes open and look out for opportunism.
Unfortunately, usually firms do not enjoy such luxury.
Therefore, they must rely on incentives to prevent opportunism.
That is they need self-enforcing contracts.
In the typical setting, if the agent finds profitable breaching the contract,
he/she will do so.
The problem is to give the agent the right set of incentives such that
he/she does not want to breach the contract.
This point leads us to the next topic of the lesson:
how to design the agent’s incentives.
We are ready to talk about the last topic of this lesson: The incentive problem.
Hannes LangResearch Associate
Luisa MenapaceProfessor
Faical AkaichiResearch Economist
Francesco BimboResearch Economist
Montserrat Costa-FontResearch Economist
Carlo RussoAssociate Professor
Chenguang LiResearch Economist
