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The role of the agent's outside options in principal-agent relationships

  • Rasul, Imran
  • Sonderegger, Silvia

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 may equip 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 efficiency of the optimal second-best contract.

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Article provided by Elsevier in its journal Games and Economic Behavior.

Volume (Year): 68 (2010)
Issue (Month): 2 (March)
Pages: 781-788

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Handle: RePEc:eee:gamebe:v:68:y:2010:i:2:p:781-788
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622836

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  1. Richard Arnott & Joseph E Stiglitz, 2010. "Randomization with Asymmetric Information," Levine's Working Paper Archive 2054, David K. Levine.
  2. Hart, Oliver D. & Moore, John, 1990. "Property Rights and the Nature of the Firm," Scholarly Articles 3448675, Harvard University Department of Economics.
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  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. 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.
  6. Jullien, Bruno, 1997. "Participation Constraints in Adverse Selection Models," IDEI Working Papers 67, Institut d'Économie Industrielle (IDEI), Toulouse.
  7. Grossman, Sanford J. & Hart, Oliver D., 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Scholarly Articles 3450060, Harvard University Department of Economics.
  8. 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.
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