Agency Theory

Jorge Rodríguez

Suppose that the owner of a firm (Principal) is too busy to run her firm, so she needs
to hire someone (Agent) to do the job. She is also too busy to monitor the Agent every
second of the day. Agency theory deals with the following question: how can we motivate
the Agent?
In this course, we will often talk about incentives. We start by discussing monetary
incentives, but they can be of other nature, as we will see later on.

1 The model

1.1 Production function

• The agent’s contribution to the firm’s value is y. E.g.: Number of computers sold,
change in stock-market value thanks to the introduction of a new webpage. It is
difficult to measure; here, we will assume we actually can.

• The agent takes an action a. E.g.: Number of calls to sell computers, hours worked in
a new web page design.

• There are events beyond the control of the agent, denoted by . E.g: A negative income
shock in the demand for computers. Electrical shut down in the case of the designer.
We will assume E() = 0.

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The link between the Agent’s actions and production is summarized in a production function:

y = a + .

1.2 Contract

Suppose we have the following payment scheme:

w = s + by

Here, w is total compensation.

Examples:

• Base salary of worker is s = 300, 000 pesos, but wins b = 200, 000 pesos for every
compute she sells.

• Example: a worker earns 300,000 pesos if output is less than a target ȳ. If output is
greater than 300,000 pesos, then she earns 1,000,000 pesos. This is a bad contract.
Why?

1.3 Payoffs

The Principal receives y from the worker but pays w. Her profits are

π = y − w.

The Principal is risk neutral. What does this mean about her behavior? She maximizes
E(π).1
The Agent receives w for taking action a. What is her cost?

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See Appendix A for details.

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 Figure 1: Cost function

𝑐(𝑎)

Notes: The figure shows the subjective monetary value for providing different levels of effort.

The cost for taking an action a is supplying “effort.” Effort has no monetary value, but
we assume we can monetize it with c(a). c(a) is how many pesos would it take to compensate
the agent for providing effort or action a.
The cost function has the following shape:
The figure implies:

1. Cost of doing nothing is zero.

2. More action or effort is more costly.

3. A small increase in effort is more costly when the Agent is already making big effort.
Suppose a is working hours. What does this imply?

The agent’s utility can be denoted by

U = w − c(a)

Just like principal, the Agent is risk neutral and so she only wants to maximize the
expected value of her utility E(U ) = E(w) − c(a).

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1.4 Timing

• Principal and Agent agree to this contract: w = s + by

• Agent chooses an action a and there are events beyond her control (). Both things
determine y.

• The Principal does not observe a.

• y is observed by both the Principal and Agent.

• The Agent receives w.

1.5 Choices

Questions:

• Which variable is in control of the agent?

• What is the objective of the Agent?

Note

E(U ) = E(w − c(a))

= E(s + by − c(a))

= E(s + b(a + ) − c(a))

The only source of uncertainty is . So E(U ) = s + ba − c(a).

How does the Agent choose?

max
a
{s + ba − c(a)}

Taking derivative with respect to a, the FOC:

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 b − c0 (a∗ ) = 0

where c0 (a) is the marginal cost of a and a∗ is the optimal level chosen by the consumer
In English:

• The marginal benefit for supplying one additional unit of effort is b

• The marginal cost for supplying one additional unit of effort is c0 (a).

The FOC implies that, at the optimal level, marginal cost equals marginal cost. Why? Take
a0 6= a∗

• If b > c0 (a0 ) then the Agent is better off by supplying more effort. In this case, more
effort increases c(a0 ).

• If b < c0 (a0 ) then the Agent is better off by reducing her level of effort.

• Hence, the optimal must but to choose a∗ such that b = c0 (a∗ ).

Graphically, the optimal a is such that the slope of the cost function equals the slope of the
wage contract (Figure 2).
Suppose the contract specifies a higher b (b̄ > b). What then?
Intuitively, we should expect the Agent to revise her decision. A higher b implies that the
Agent receives more money for the same level of action/effort. Hence, at a∗ , the marginal
benefit b̄ > b = c(a∗ ). Then, her optimal choice involves increasing her effort. How does this
look like in our picture?
Is a higher b always better for the Principal? Not always. Higher b means less profits π.
However, we do see contracts where s < 0 and b is near 1. Where? Franchises. The Agent
pays for the right to “work” but she gets almost all output (b = 1).
Note that b can be used as an instrument by the Principal to induce the Agent to exert
effort. But how strong incentives should be? This is the topic of the next module.

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 Figure 2: Optimal effort choice

$ 𝐸 𝑤 = 𝑠 + 𝑏𝑎

𝑎∗ 𝑎

Notes: The figure represents the optimal choice of effort a∗ of an agent whose expecte salary equals E(w) = s + ba and has a
upward-sloping, convex cost function.

1.6 Back to reality

Is this model a decent representation of reality? A straightforward extension is the fact that
the Principal does not observe y. However, she has a performance measure p.
Now, the Agent can exert two types of efforts, a1 and a2 :

• Both a1 and a2 contribute to p.

• However, only a1 contributes to y.

• Examples: call-center worker paid according to how many calls the Agent makes.

In this case, the optimal choice by the Agent involves a∗2 > 0: she will waste resources
(money/time) in just increasing her performance.
In the extreme case where a1 does not affect p, then b cannnot be used to create incentives.
We will see other sources of incentives (e.g., intrinsic versus extrinsic motivation).

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A Uncertainty

Expected utility Often, consumers face uncertainty when making choices. For example,
the consumer is given two choices. Which one is better?

1. To receive a mutual fund that pays w1 with probability p1 or w2 with probability 1−p1 .
Suppose w1 > w2 but p1 < 0.5.

2. To receive a safe payment of w2 < w3 < w1 .

Let us define a lottery as the set of goods with their associated probabilities. (w1 ◦p1 ), (w2 ◦
1 − p1 ) is a lottery.
Rationality in this context is again defined by completeness, transitivity, and monotonic-
ity. How can these assumptions be applied to this context? Think about a “lottery” as a
bundle of goods. Under rationality we can define U ((w1 ◦p1 ), (w2 ◦ 1 − p1 )).
Suppose two gambles. L1 consists of a payment of 50 dollars. L2 = (100◦0.5), (0◦0.5).
What do you prefer? Many would say that U (L1 ) > U (L2 ).
Under rationality and other mild technical assumptions,2 the following is true:

U ((w1 ◦ p1 ), (w2 ◦ 1 − p1 )) = p1 u(w1 ) + (1 − p1 )u(w2 )

The equation above illustrates the expected utility property. The utility of a lottery equals
the utility of its prizes weighted by probabilities. (Remember from your metrics class the
concept expected value). Does somebody wish to change their answer?

Attitudes toward risk A consumer is said to be risk averse if the utility of a lottery
U ((w1 ◦ p1 ), (w2 ◦ 1 − p1 )) is less than the utility of the expected value of the lottery U (p1 w1 +

2
Rationality in consumer theory is understood as a consumer whose preferences meet the properties
of completeness, transitivity, and monotonicity. Suppose there are only three goods available, x1 , x2 , and
x3 . Completeness means that the agent must have a complete subjective rank of potential bundle of goods
available in the market. Preferences are transitive if a consumer prefers bundlle A over B, and B over C,
then she must prefer A over C. Monotonicity means “more is better.”

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 Figure 3: Risk aversion

Notes:

(1 − p1 )w2 ). Hence, the consumer is better off by accepting the average, monetary value of
the lottery instead of taking the gamble.
If the opposite is true, the consumer is “risk loving.”
How would risk loving be represented in the figure? Note that the degree of risk aversion
is related to the curvature of the utility function.
A risk neutral consumer is such that the utility of the lottery equals the expected value
of the lottery. We will use the risk-neutral assumption often.