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

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Author Info
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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Publisher 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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Related research
Keywords: adverse selection; randomization; type-dependent outside options.;

Find related papers by JEL classification:
D21 - Microeconomics - - Production and Organizations - - - Firm Behavior
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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  2. 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. [Downloadable!] (restricted)
  3. Strausz, Roland, 2006. "Deterministic versus stochastic mechanisms in principal-agent models," Journal of Economic Theory, Elsevier, vol. 128(1), pages 306-314, May. [Downloadable!] (restricted)
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  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. [Downloadable!] (restricted)
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  5. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 691-719, August. [Downloadable!] (restricted)
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  6. Mirrlees, James A, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Blackwell Publishing, vol. 38(114), pages 175-208, April. [Downloadable!] (restricted)
  7. Richard J. Arnott & Joseph E. Stiglitz, 1988. "Randomization with Asymmetric Information," NBER Working Papers 2507, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Maggi G. & Rodriguez-Clare A., 1995. "On Countervailing Incentives," Journal of Economic Theory, Elsevier, vol. 66(1), pages 238-263, June. [Downloadable!] (restricted)
  9. Jullien, Bruno, 2000. "Participation Constraints in Adverse Selection Models," Journal of Economic Theory, Elsevier, vol. 93(1), pages 1-47, July. [Downloadable!] (restricted)
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