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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. Oliver Hart & Sanford Grossman, 1985. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Working papers 372, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Jullien, Bruno, 2000. "Participation Constraints in Adverse Selection Models," Journal of Economic Theory, Elsevier, vol. 93(1), pages 1-47, July.
  3. Richard Arnott & Joseph E Stiglitz, 2010. "Randomization with Asymmetric Information," Levine's Working Paper Archive 2054, David K. Levine.
  4. Hart, Oliver & Moore, John, 1990. "Property Rights and the Nature of the Firm," Journal of Political Economy, University of Chicago Press, vol. 98(6), pages 1119-58, December.
  5. Maggi G. & Rodriguez-Clare A., 1995. "On Countervailing Incentives," Journal of Economic Theory, Elsevier, vol. 66(1), pages 238-263, June.
  6. Brito, Dagobert L. & Hamilton, Jonathan H. & Slutsky, Steven M. & Stiglitz, Joseph E., 1995. "Randomization in optimal income tax schedules," Journal of Public Economics, Elsevier, vol. 56(2), pages 189-223, February.
  7. 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.
  8. 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.
  9. Roland Strausz, . "Deterministic versus Stochastic Mechanisms in Principal--Agent Models," Papers 020, Departmental Working Papers.
  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. Englmaier, Florian & Muehlheusser, Gerd & Roider, Andreas, 2014. "Optimal incentive contracts for knowledge workers," European Economic Review, Elsevier, vol. 67(C), pages 82-106.
  2. Englmaier, Florian & Muehlheusser, Gerd & Roider, Andreas, 2010. "Optimal Incentive Contracts under Moral Hazard When the Agent is Free to Leave," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 329, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  3. Jullien, Bruno & Pouyet, Jérôme & Sand-Zantman, Wilfried, 2013. "An Offer You Can't Refuse: Early Contracting with Endogenous Threat," IDEI Working Papers 783, Institut d'Économie Industrielle (IDEI), Toulouse, revised Jun 2014.
  4. Stefan Terstiege, 2011. "Randomization in contracts with endogenous information," Bonn Econ Discussion Papers bgse07_2011, University of Bonn, Germany.
  5. Goldlücke, Susanne & Schmitz, Patrick W, 2011. "Investments as Signals of Outside Options," CEPR Discussion Papers 8366, C.E.P.R. Discussion Papers.

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