CONTRACTS October 3, 2006
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Transcript of CONTRACTS October 3, 2006
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CONTRACTSOctober 3, 2006
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BILATERAL AGENCYCONTRACTS
Contracts
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BILATERAL AGENCYCONTRACTS
. Bilateral Agency
Property RightsPrimarily “imposed rules” with some scope for contracting within the imposed frameworkHorizontal –joint or group rightsVertical – many landlord
and tenant cases
- subordinate possession
ContractsPrimarily “voluntary rules” with some scope for contracting hierarchiesHorizontal – equal partnersVertical – creating subordinate agents – most common form of contract
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PRINCIPAL – AGENCYCONTRACTS
Principal
AGENT
promisepayment
“SUPER”Principal Its “problem” is to maximize social
surplus
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PRINCIPAL – AGENCYCONTRACTS
• This “Principal-Agency ” exchange model is the principal model featured in Cooter's treatment of contract law
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PRINCIPAL – AGENCYCONTRACTS
Formation Of Contracts
Principal Makes
An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
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FORMATION OF CONTRACTS
CAPACITY
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FORMATION OF CONTRACTS
• Competent Parties: • Both parties must have the capacity to
understand the terms of the contract they are entering into, and the consequences of the promises they make.
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FORMATION OF CONTRACTS
• For example, animals, minor children, and mentally disabled individuals do not have the capacity to form every contract
• Any contracts with them will be considered void or voidable.
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FORMATION OF CONTRACTS
• Corporations are considered persons under the law, and thus competent to engage in contracts.
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FORMATION OF CONTRACTS
SUBJECT-MATTER
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FORMATION OF CONTRACTS
• Proper Subject Matter:
• The contract must have a lawful purpose.
• A contract to commit murder in exchange for money will not be enforced by the courts.
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FORMATION OF CONTRACTS
FORMALITIES
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FORMATION OF CONTRACTS
• Need for a written contract?• A spoken contract is often called an "
oral contract", not a "verbal contract". • A verbal contract is simply a contract that
uses words. Most oral contracts and written contracts are verbal contracts.
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FORMATION OF CONTRACTS
• Need for a written contract?• An informal exchange of promises may be
binding and legally as valid as a oral or a written contract.
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FORMATION OF CONTRACTS
• Statutory Regulation of Contracts• The Statute of Frauds requires that contracts
pertaining to land be in writing. • The Statute of Frauds attempts to prevent false
allegations of the existence of contracts that were never made.
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FORMATION OF CONTRACTS
OFFER
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FORMATION OF CONTRACTS
• Offer
• Acceptance
• Exchange
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FORMATION OF CONTRACTS
• Offer
• Principal writes the document, but the document does not become a contract until the agent signs it
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FORMATION OF CONTRACTS
• Offer
• In presenting the written document to the agent as the first step for its review the parties are following a form of the Prisoner’s dilemna that is sequential and not simultaneous
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FORMATION OF CONTRACTS
• Offer
• The classical “bargaining theory of contract law assigns the legal word “offer” to the document
• Note – What judges say and due involves language. What one observes them do and why is the domain of
economic analysis
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FORMATION OF CONTRACTS
• Offer
• Another way of characterizing “the first step”, taken by the principal is to describe the principal as the “first mover”
• (Cooter and Ulen, Law and Economics, 4th edn, Addison-Wesley, Longman, 2004, at p. 196)
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FORMATION OF CONTRACTS
• Offer
• Principal writes the document, with a view to selecting several potential agents
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FORMATION OF CONTRACTS
• Offer• In an “economic” sense, this step follows the Stackelberg process of a Principal that maximizes the profit or utility of the “agent” as part of its profit or utility maximizing step
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FORMATION OF CONTRACTS
• Offer• Cooter assumes that the Principal-
Agency game is played as a Stackleberg game
• Before making the “first move”, the Principal considers the “second move” that would be made by the Agent
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FORMATION OF CONTRACTS
• A boss designing a contract for a worker (which, usually but not always, must satisfy a “participation constraint” that the worker be willing to accept it instead of quitting the job)
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FORMATION OF CONTRACTS
• Offer
• The Agent’s “incentive compatibility constraint” is binding
A(CA(a) – 1) = 0
A > 0
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FORMATION OF CONTRACTS
• Offer
• The offer generates an agency cost
• This agency cost depends upon the amount of effort provided by the agent
• This cost enters the “contract problem” through the incentive constraint.
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FORMATION OF CONTRACTS
• Offer• This agency cost is usually described
as a disutility of effort or a benefit from shirking or foregone pleasurable activities.
• This agency cost is the marginal cost of effort and may vary with effort.
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FORMATION OF CONTRACTS
• Offer• If the Agent “would co-operate”, the
“first move” occurs by the Principal• If the Agent “would not cooperate”,
then no “first move”• No Offer• No Contract
• (Cooter, Figure 6.1, 4th p. 197)
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FORMATION OF CONTRACTS
• Offer (Advertising)
• How, where, when and what?
• Carlill v. Carbolic Smoke Ball Company [1893] 1 QB 256; Court of Appeal, 1892 Dec. 6,7, LINDLEY, BOWEN and A. L. SMITH, L.JJ.
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FORMATION OF CONTRACTS
ACCEPTANCE
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FORMATION OF CONTRACTS
• Acceptance
• If there is only one Agent, he or she has the choice of accepting or rejecting the offer
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FORMATION OF CONTRACTS
• Acceptance
• If the Agent or group of Agents reject the offer, the contract game is over
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FORMATION OF CONTRACTS
• Acceptance
• The classical “bargaining theory of contract law assigns the legal word “acceptance” to the document if the Agent or one of the Agents accepts the offer
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FORMATION OF CONTRACTS
• Acceptance
• Another way of characterizing “the second step”, taken by the agent is to describe the agent as the “second mover”
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FORMATION OF CONTRACTS
•Acceptance
•The “participation constraint” of the Agent is binding
A (TA + C(a) - a) = 0
A > 0
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FORMATION OF CONTRACTS
• Acceptance • Acceptance of the offer generates a
“second” agency cost.• The second agency cost is the opportunity
cost of the agent participating in the contract.
• It is also referred to as a reservation utility (0) and enters into the “contract problem” through the participation constraint.
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FORMATION OF CONTRACTS
Performance
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FORMATION OF CONTRACTSPerformance
Formation Of Contracts
Principal Makes
An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
Agent Sends A
Signal to the
Principal
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FORMATION OF CONTRACTSPerformance
.AGENT(Chosen)
PRINCIPAL
Promise To PerformPayment For Performance
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FORMATION OF CONTRACTSPerformance
• Parties enter into a “principal-agency” contract:
0 = input of Principal
a = input of Agent
y = C(0,a) = output of the contract
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FORMATION OF CONTRACTS
• Performance
• The parties perform the contract in accordance with an agreed upon exchange
•The “principal” makes an exchange of a “payment” to an “agent”
•The “agent” performs or executes a “promise” for the “principal”
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FORMATION OF CONTRACTS
• Performance
• If the principal is operating in a perfectly competitive market outside of its relationship with the agent, its longrun profit function = 0
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FORMATION OF CONTRACTS
U(F)
F=Output
E
There is a “third” constraint” in the Principal – Agency Problem
The “Budget Constraint” of the Principal
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FORMATION OF CONTRACTS
• Performance
• This agency has the following profit function:
(0,a) = C(0,a) - a
or
(a) = C(a) - a
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FORMATION OF CONTRACTS
Principal
PAYMENT
Agent
PROMISED PERFORMANCE
Agent
PARTICIPATIONCONSTRAINT
INCENTIVE COMPATIBILITYCONSTRAINT
LEGAL ANALYSIS
PROMISED
ECONOMIC ANALYSIS
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FORMATION OF CONTRACTS
U(F)
F=Output
E
A “perfectly competitive” risk neutral Principal contracts a “complete” contract with the “risk averse” agent
Contract Equilibrium Point
The parties are paid in “output” shares
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FORMATION OF CONTRACTS
• Performance
• One of the primary conclusions of the Principal-Agency contract model is that, because
• (1) the agent receives only a partial share of the profits generated from the agent’s effort,
• (2) the agent’s effort is not perfectly observed by the principal, and
• (3) the agent bears the entire cost of that effort,
the optimal incentive contract between the principal and agent cannot achieve a Pareto optimal outcome.
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FORMATION OF CONTRACTS
• Performance
• Even with risk neutrality on the part of both parties, moral hazard and inefficiency remain as long as there is a cost of effort born only by the agent and the agent receives only a share of the benefits generated by that effort
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FORMATION OF CONTRACTS
• Performance
• The principal is unable to costlessly observe (or verify) the agent’s actions
• The sub-optimal contract results in moral hazard and inefficiency.
• The principal’s value and the total value of the agent’s effort are not maximized.
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FORMATION OF CONTRACTS
• Performance = “Solution” to the “contract problem”
(a) = C(a) - a
A(CA(a) – 1) = 0 A > 0
A (TA + C(a) - a) = 0 A > 0
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FORMATION OF CONTRACTS
L(a) = C – a + A(CA – 1)+ A (TA + C - a)
dL/da = 0 impliesCAA + ACAA + A(CA - 1) = 0dL/d = 0 implies 1 = ACA/C + A
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FORMATION OF CONTRACTS
Solving
CAA + ACAA + A(CA - 1) = 01 = ACA/C + A
proves
(a*) = C(a*) - a* and C(a*) – a* are are optimal if because the principal applies no effort
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PERFORMANCE OF CONTRACTSExample
Principal – Buyer - Contract
• A seller owns a house she values at $300,000.00
• A buyer has $500,000.00 but values the house at $400,000.00
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PERFORMANCE OF CONTRACTSExample
U(F)
F=Output
E
A Principal (buyer) contracts a “complete” contract with the “risk averse” Agent (seller)
Contract Equilibrium Point
The parties are paid in “output” shares
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PERFORMANCE OF CONTRACTS Example
• If the parties fail to agree on a price, P, social surplus between the parties is sub-optimal at $800,000.00
• SS = SSA + SSB
= $300,000.00 + $500,000.00 = $800,000.00
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PERFORMANCE OF CONTRACTS Example
Principal – Buyer - Contract
P(Vs, VB) = P(300,000, 400,000)
maximizes
SSB = (500,000 - P) + 400,000
subject to
SSs = P
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PERFORMANCE OF CONTRACTS Example
• Principal Buyer Contract• Sequential Solution
If the parties successfully agree on a price, P, social surplus between the parties is optimize at $900,000.00
• SS = SSA + SSB
= P + [($500,000.00 – P) + $400,000.00]
= $900,000.00
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PERFORMANCE OF CONTRACTSExample
U(F)
F=Output
350,000.00Nash Equilibrium
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FORMATION OF CONTRACTS
CompetingAgents
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FORMATION OF CONTRACTSAdverse Selection
.AGENT 1 AGENT 2
PRINCIPAL ASYMMETRIC INFORMATION
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FORMATION OF CONTRACTSAdverse Selection
In the “adverse selection” game the agents have some information the principal does not know.
(See http://graphicsdept.com/melfarr7/)
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FORMATION OF CONTRACTSAdverse Selection
• The question arises?
• What if the principal cannot discern the type of agent or the law says that they cannot use this information?
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FORMATION OF CONTRACTSAdverse Selection – Example
• Privacy laws prevent employers from accessing student university marks without the student's written consent.
• So if all students agree to keep their marks private no prospective employer can get anyone's marks.
• So everybody's job search is on a level playing field.
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FORMATION OF CONTRACTSAdverse Selection – Example
• An application is submitted by student A. No transcript is provided. Employer assumes A was probably an “average student” (68 or GPA 2.5?)
• Student A got 84 and G.P.A. 3.7. What do you predict A will do?
• Eventually all the above average students give permission to release their marks.
• (Posner, 6th ed., c. 1, p. 20)
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FORMATION OF CONTRACTSAdverse Selection – Example
• Now what happens? • The employer assumes the students
who did not submit their transcripts are “below average”.
• Their marks are somewhere between 68 and 0.
• The student closest 68 will release his marks and so on until only the student that got the lowest mark is left.
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FORMATION OF CONTRACTSAdverse Selection – Example
• Strategic behaviour prevented students from pursuing differentiated behaviour.
• Instead they strategically pursued a form of “common behaviour”
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FORMATION OF CONTRACTSAdverse Selection – Example
• Economists and game theorists describe as a “pooling equilibrium” (Posner, 6th ed., c. 1, p. 21)
• Cooter explains adverse selection –
(4th ed., 2004, c. 2., X, p. 54)
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FORMATION OF CONTRACTSAdverse Selection
• Alternatively, the law might forbid the principal from acting on information that the principal does have on the agents
Example: laws against discrimination
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BILATERAL AGENCY - EXPLICIT Vertical Contract – (Principal – Agency)
U(F)
F=Output
EH EL
A “perfectly competitive” risk neutral Principal contracts a “complete” contract with the agents
In this case two “different” agents – “two” different contracts
H – high risk agentL- low risk agent
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FORMATION OF CONTRACTSAdverse Selection
The objective of the Principal is that the two (2) types of agents reveal themselves through the choice of written contracts the Principal writes and the agents accept
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FORMATION OF CONTRACTSAdverse Selection
Can agents with different risk preferences or other characteristics be determined or sorted out through their choice of contract?
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FORMATION OF CONTRACTSAdverse Selection
U(F)
F
EH
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FORMATION OF CONTRACTSAdverse Selection
• In a “perfectly competitive” market, the principal will want to offer the “more profitable high risk contract” to BOTH agents
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FORMATION OF CONTRACTSAdverse Selection
•This will “adversely select” against the “low risk agent” who will opt for “no contract” or a “sub-optimal” contract•The “exchange point” of the adversely selected group lies in the area indicated by the red arrow
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FORMATION OF CONTRACTSAdverse Selection
U(F)
F
EH
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FORMATION OF CONTRACTSAdverse Selection
•In this equilibrium, adverse selection occurs against the low risk agents. •So some “low risk agents” leave the market
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FORMATION OF CONTRACTSAdverse Selection
U(F)
F
EH EL
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FORMATION OF CONTRACTSAdverse Selection
The high risk budget constraint acts as an incentive compatibility constraint on the low risk agents who either drop out of the market entirely or agree to a suboptimal exchange In other words, high-risk agents impose a negative “risk” externality on low-risk agents
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FORMATION OF CONTRACTSAdverse Selection
W2
W1
EH
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CONTRACTS - OFFERS
Formation Of Contracts
Principal Makes
An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
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BILATERAL AGENCY - EXPLICIT
SEPARATING EQUILIBRIA
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CONTRACTS - OFFERSSeparating Equilibria
The separating equilibrium in this market entails a welfare loss – a reduction in social surplus.
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CONTRACTS - OFFERSSeparating Equilibria
Under the Rothschild-Stiglitz hypothesis, the principals and agents act non-strategically.
Neither principals nor agents anticipate the others’ possible reactions when deciding their strategy.
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CONTRACTS - OFFERSSeparating Equilibria
U(F)
F
E3
E4
Area where Principal lose money
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CONTRACTS - OFFERSSeparating Equilibria
In the separating equilibrium the two types of risk averse agents “sort” the exchanges out among themselves so that: (i) the low-risk group gets
incomplete bargain EL (ii) the high-risk group gets
complete bargain EH
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CONTRACTS - OFFERSSeparating Equilibria
U(F)
F
EH EL
Area where principals lose money
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CONTRACTS - OFFERSSeparating Equilibria
The separating equilibrium “sorts” the contracts so that: (i) the low-risk agents gravitate
towards the less than optimal equilibrium EL
(ii) the high-risk agents gravitate
towards the optimal equilibrium EH
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BILATERAL AGENCY - EXPLICIT
POOLING EQUILIBRIA
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CONTRACTS - OFFERSPooling Equilibria
In 1976, C. Wilson removed the Rothschild-Stiglitz hypothesis. He altered the perfect competitive characterization of principals' supply to one of oligopoly. This permits principals to act strategically.
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CONTRACTS - OFFERSPooling Equilibria
More specifically, oligopoly on the supply side also requires principals behave non-competitively.
The principals make “some” profit instead of negative profits at the pooling equilibrium point.
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CONTRACTS - OFFERSPooling Equilibria
So under Wilson’s revision, the pooling equilibrium preferred by the low-risk agents becomes stable provided there are suitably few high-risk agents in the market
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CONTRACTS - OFFERSPooling Equilibria
U(F)
F
E3
E4
Pooling constraint
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CONTRACTS - OFFERSPooling Equilibria
When the percentage of high-risk agents is small enough, low-riskagents prefer to cross-subsidize exchanges for high-risk agents in the pooling equilibrium rather than accept a lower level of coverage in the separating equilibrium.
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BILATERAL AGENCY - EXPLICIT
SCREENING
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CONTRACTS - OFFERS
Screening
A screening game is an adverse selection game where the uninformed party (principal) is the first mover.
Example: A principal offers a selection of contracts that “sort” out the agents
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CONTRACTS - OFFERS
Screening
• Screening is an action taken by the uninformed principal to determine information possessed by informed agents
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CONTRACTS - OFFERS
Screening
Examples: (1) Buyer test driving different used cars(2) Insurance company setting premiums based on age, marital status
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BILATERAL AGENCY - EXPLICIT
SIGNALING
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CONTRACTS - NEGOTIATION
Signalling
Formation Of Contracts
Principal Makes
An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
Agent Sends A
Signal to the
Principal
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CONTRACTS - NEGOTIATION
Signalling
A signaling game is an adverse selection game where the informed party (agent) is the first mover.
Example: An agent “advertises”
(1) posts a resume
(2) offers a warranty
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CONTRACTS - NEGOTIATION
Signalling
• Action taken by an informed person to send information to a less-informed person
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CONTRACTS - NEGOTIATION
Signalling
Also for signals to be effective the cost of sending the signal should vary with type otherwise everybody would send the same signal and the signal would be of no use.