William P. Rogerson

THE FIRST-ORDER APPROACH TO PRINCIPAL-AGENT PROBLEMS

The first-order approach to principal-agent problems involves relaxing the constraint that the agent choose an action which is utility maximizing to require instead only that the agent choose an action at which his utility is at a stationary point. Although more mathematically tractable, this approach is generally invalid. This paper identifies sufficient conditions-the monotone likelihood ratio condition and convexity of the distribution function condition-for the first-order approach to be valid. The Pareto-optimal wage contract is shown to be nondecreasing in output under these same conditions. MIRRLEES [5] WAS THE FIRST to point out that the standard method for analyzing the principal-agent problem is not generally correct. This method, the so-called first-order approach, involves weakening the constraint that the agent choose a utility-maximizing action to require instead only that the agent choose an action at which his utility is at a stationary point. The resulting problem is more mathematically tractable. However, as Mirrlees [5] has shown, necessary conditions for a contract to solve the first-order program are not generally even necessary conditions for the valid program. Therefore qualitative propositions about the nature of the Pareto-optimal contract derived from the first-order approach are not in general valid. This has motivated researchers to try to identify classes of cases where the first-order approach is valid.

Intertemporal Cost Allocation and Managerial Investment Incentives: A Theory Explaining the Use of Economic Value Added as a Performance Measure

This paper provides a formal analysis of how managerial investment incentives are affected by alternative allocation rules when managerial compensation is based on accounting measures of income that include allocations for investment expenditures. The main result is that there exists a unique allocation rule that always induces the manager to choose the efficient investment level. The income measure created by this allocation rule is usually referred to as residual income or economic value added.

Contractual Solutions to the Hold-Up Problem

This paper considers a general version of the hold-up problem where n agents first make relation-specific investments and then must agree on some collective action. It is shown that first-best solutions exist under a variety of different assumptions about the nature of information asymmetries.

Reputation and Product Quality

This article considers the role that reputation plays in assuring product quality in markets where consumers can only imperfectly judge product quality even after consumption. Three conclusions are derived. First, high quality firms have more customers because they have fewer dissatisfied customers who leave and word-of-mouth advertising results in more arrivals. Second, higher fixed costs can result in a higher equilibrium level of quality. Third, the particular form that word-of-mouth advertising takes can have significant effects on the market outcome. Recommendations consisting of a report of whether the consumer intends to patronize the same firm again generate an externality that is absent when actual estimates of quality are communicated.

Efficient reliance and damage measures for breach of contract

This article considers a situation where the buyer or the seller of a good must engage in expenditures on specific capital before the exchange either to prepare to use the product or to prepare to sell it. It is assumed that postbreach bargaining is possible and carried out in a cooperative fashion, and that buyers and sellers form expectations about the outcome of such bargaining in a specific way. Without enforceable contracts, the potential appropriability of specific rents results in inefficiently low levels of investment. Three damage measures commonly used to enforce contracts are shown to produce inefficiently high levels of investment and to be Pareto-ranked from best to worst as follows: specific performance, expectation damages, and reliance damages.

Products Liability, Consumer Misperceptions, and Market Power

This paper compares alternative liability rules for allocating losses from defective products when consumers under- estimate these losses and producers may have some market power. If producers do not have any market power, the rule of strict liability .leads to both the first-best accident probability and industry output. If producers do have some market power, strict liability still leads to the first-best accident probability, but there will now be too little output of the industry. It is shown that if market power is sufficiently large, a negligence rule is preferable. Under this rule, firms can still be induced to choose the first-best accident probability, but now the remaining damages are borne by consumers. Since consumers underestimate these damages, they buy more than under strict liability. However, there is a limit to how much the negligence rule can encourage extra consumption. It is shown that if market power is sufficiently large, the rule of no liability may then be preferred to the negligence rule. Without any liability imposed, producers will not choose the first-best accident probability. However, this may be more than compensated for by the increased output of the industry.

Robust Trading Mechanisms

We consider the problem of designing a trading institution for a single buyer and seller when their valuation of the good is private information. It is shown that posted-price mechanisms are essentially the only mechanisms such that each trader has a dominant strategy. A posted-price mechanism is one where a price is posted in advance and trade occurs if and only if all traders agree to trade.

The Social Costs of Monopoly and Regulation: A Game Theoretic Analysis

The theory of rent-seeking is that monopoly profits attract resources directed into efforts to obtain these profits and that the opportunity costs of these resources are a social cost of monopoly. This article shows that monopoly rents remain untransformed to the extent that firms are inframarginal in the competition for them and thereby earn profits. Different fixed organization costs can produce inframarginal firms. In a situation where a monopoly franchise is periodically reassigned, the incumbent may possess an advantage in the next years hearings. This also results in untransformed rents.

Simple Menus of Contracts in Cost-Based Procurement and Regulation

In an influential paper, Jean-Jacques Laffont and Jean Tirole (1986) formulated a principal– agent model of cost-based procurement and regulation and showed that the principal can implement the optimal mechanism by offering the agent a menu consisting of a continuum of linear contracts. Two related problems with applying this theory in practice have been that the economic logic and the underlying mathematics involved in calculating the optimal menu are quite complex, and the principal must be able to specify the agent’s entire disutility of effort function in order to calculate the optimal menu. As a result, the model has not been widely used in practice to either calculate actual incentive contracts or even to develop useful qualitative guidance about the nature of the optimal solution and how it is affected by various economic factors. The purpose of this paper is to show that dramatically simpler menus which are easy to understand and calculate and which have lower informational requirements, can, at least in some cases, capture a substantial share of the gains achievable by the fully optimal complex menu. In particular, this paper considers two-item menus where one item is a cost-reimbursement contract and the other item is a fixed-price contract. Such menus are called Fixed Price Cost Reimbursement (FPCR) menus. For the case where the agent’s utility is quadratic and the agent’s type is distributed uniformly, it is shown that the optimal FPCR menu always captures at least three-quarters of the gain that the optimal complex menu achieves (where the gain is measured relative to the result of using a cost-reimbursement contract). This paper’s research was originally motivated by a policy issue in defense procurement. In the United States, the Department of Defense (DOD) purchases almost all major weapons systems from sole-source contractors using contracting methods that essentially amount to using cost-reimbursement contracts. The best way to understand why DOD uses costreimbursement contracting methods is that they perform precisely the function identified in Laffont and Tirole’s principal–agent model; they guarantee, in a situation that amounts to a bilateral monopoly, that DOD and the firm can reach an agreement (i.e., they guarantee that the agent will always produce the good.) Of course the use of cost-reimbursement contracting methods

Profit Regulation of Defense Contractors and Prizes for Innovation

This paper argues that regulatory institutions in defense procurement are (and necessarily must be) organized to create prizes for innovation in the form of positive economic profit on production contracts. This has a number of important policy implications. The values of the prizes on 12 major aerospace projects are estimated using stock market data and shown to be large.