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The Role of the Agent's Outside Options in Principal-Agent Relationships

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  • Imran Rasul
  • Silvia Sonderegger

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Abstract

We consider a principal-agent model of adverse selection where, in order to trade with the principal, the agent must undertake a relationship-specific investment which affects his outside option to trade, i.e. the payoff that he can obtain by trading with an alternative principal. This creates a distinction between the agent’s ex ante (before investment) and ex post (after investment) outside options to trade. We investigate the consequences of this distinction, and show that whenever an agent's ex ante and ex post outside options differ, this equips the principal with an additional tool for screening among different agent types, by randomizing over the probability with which trade occurs once the agent has undertaken the investment. In turn, this may enhance the e¢ciency of the optimal second-best contract.

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Bibliographic Info

Paper provided by Department of Economics, University of Bristol, UK in its series Bristol Economics Discussion Papers with number 08/605.

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Length: 12 pages
Date of creation: Sep 2008
Date of revision:
Handle: RePEc:bri:uobdis:08/605

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Keywords: adverse selection; randomization; type-dependent outside options.;

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  1. Roland Strausz, . "Deterministic versus Stochastic Mechanisms in Principal--Agent Models," Papers 020, Departmental Working Papers.
  2. Grossman, Sanford J & Hart, Oliver, 1985. "The Cost and Benefits of Ownership: A Theory of Vertical and Lateral Integration," CEPR Discussion Papers 70, C.E.P.R. Discussion Papers.
  3. Richard J. Arnott & Joseph E. Stiglitz, 1988. "Randomization with Asymmetric Information," NBER Working Papers 2507, National Bureau of Economic Research, Inc.
  4. Dagobert L. Brito & Jonathan H. Hamilton & Steven M. Slutsky & Joseph E. Stiglitz, 1990. "Randomization in Optimal Income Tax Schedules," NBER Working Papers 3289, National Bureau of Economic Research, Inc.
  5. Lewis, Tracy R. & Sappington, David E. M., 1989. "Countervailing incentives in agency problems," Journal of Economic Theory, Elsevier, vol. 49(2), pages 294-313, December.
  6. Oliver Hart & John Moore, 1988. "Property Rights and the Nature of the Firm," Working papers 495, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Guesnerie, Roger & Laffont, Jean-Jacques, 1984. "A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm," Journal of Public Economics, Elsevier, vol. 25(3), pages 329-369, December.
  8. Maggi G. & Rodriguez-Clare A., 1995. "On Countervailing Incentives," Journal of Economic Theory, Elsevier, vol. 66(1), pages 238-263, June.
  9. Jullien, Bruno, 2000. "Participation Constraints in Adverse Selection Models," Journal of Economic Theory, Elsevier, vol. 93(1), pages 1-47, July.
  10. Mirrlees, James A, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Wiley Blackwell, vol. 38(114), pages 175-208, April.
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Cited by:
  1. Goldlücke, Susanne & Schmitz, Patrick W., 2014. "Investments as signals of outside options," Journal of Economic Theory, Elsevier, vol. 150(C), pages 683-708.
  2. Jullien, Bruno & Pouyet, Jérôme & Sand-Zantman, Wilfried, 2013. "Divide and Learn: Early Contracting with Endogenous Threat," IDEI Working Papers 783, Institut d'Économie Industrielle (IDEI), Toulouse.
  3. Englmaier, Florian & Muehlheusser, Gerd & Roider, Andreas, 2014. "Optimal incentive contracts for knowledge workers," European Economic Review, Elsevier, vol. 67(C), pages 82-106.
  4. Englmaier, Florian & Muehlheusser, Gerd & Roider, Andreas, 2010. "Optimal Incentive Contracts under Moral Hazard When the Agent is Free to Leave," CEPR Discussion Papers 7914, C.E.P.R. Discussion Papers.
  5. Stefan Terstiege, 2011. "Randomization in contracts with endogenous information," Bonn Econ Discussion Papers bgse07_2011, University of Bonn, Germany.

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