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,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Mike Shor,*,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Mike Shor,*,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Mike Shor,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Mike Shor,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Mike Shor,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Mike Shor,Game Theory,“A little knowledge is a dangerous thing.So is a lot.,-Albert Einstein,Topic 7Information,Strategic Use of Information,Incentive Schemes,Creating situations in which observable,outcomes,reveal the unobservable,actions,of the opponents.,Screening,Creating situations in which the better-informed opponents observable,actions,reveal their unobservable,traits,.,Mike Shor,2,Moral Hazard&Roulette,Mike Shor,3,$50,Moral Hazard,A project with uncertain outcome,Probability of success depends on firms effort,prob.of success=0.6 if effort is routine,prob.of success=0.8 if effort is high,Firm has cost of effort,cost of routine effort=$100,000,cost of high effort=$150,000,project outcome=$600,000 if successful,Mike Shor,4,Compensation Schemes,Benchmarks:,Fixed Payment,Observable Effort,Result-contingent bonus scheme,Mike Shor,5,Incentive Scheme 1:Fixed Payment,A fixed payment must be high enough to get the firm to accept the project,No amount of fixed payment can change the firms behavior once it accepts the project,Mike Shor,6,Incentive Scheme 1:Fixed Payment,For any fixed payment,effort will be low:,Payment-$100,000 Payment-$150,000,Optimal Payment,Lowest possible,Firm requires at least$100,000,Payment=$100,000,Expected Profit,Value of project payment,=(.6)$600K$100K,=$360-$100=,$260K,Mike Shor,7,Incentive Scheme 2:Observable Effort,If we can observe effort,contracts are simple:,Work as hard as we tell you to,or you are fired,Only question:,How hard do we want employees to work?,Remember,salary must be commensurate with level of effort,or no one will take the job,Mike Shor,8,Incentive Scheme 2:Observable Effort,Firm puts in the effort level promised,given its pay,Pay for routine effort:,Avg.Profit=(.6)600,000 100,000=$260,000,Pay additional$50K for high effort:,Avg.Profit=(.8)600,000 150,000=$330,000,If effort is observable,pay for high effort,Expected Profit=,$330K,Mike Shor,9,Problems,Fixed payment scheme offers no incentives for high effort,High effort is more profitable,Worst case scenario:$260K,Effort-based scheme cannot be implemented,Cannot monitor firm effort,Best case scenario:$330K,Question:how close can we get to best case scenario if effort is unobservable?,Mike Shor,10,Incentive Scheme 3:Fixed Payment and Bonus,Suppose effort can not be observed,Incentive-Compatible compensation,Compensation contract must rely on something that can be directly observed and verified.,Projects success or failure,Related,probabilistically,to effort,Imperfect but positive information,Mike Shor,11,Observable Outcome,Incentive Compatibility,(high low),Putting in high effort,must be better than,putting in low effort,Participation Constraint,(high none),Putting in high effort,must be better than,not taking the contract,Mike Shor,12,Incentive Compatibility,Compensation Package(f,b),f:fixed base payment,b:bonus if the project succeeds,Mike Shor,13,Incentive Compatibility,If Firm puts in high effort,80%chance of bonus,cost of$150K,Profit:f+(0.8)b 150K,If Firm puts in low effort,60%chance of bonus,cost of$100K,Profit:f+(0.6)b 100K,If Firm does not take contract,Profit:0,Mike Shor,14,Incentive Compatibility,Firm will put in high effort if,f+(0.8)b-150,000,f+(0.6)b-100,000,(0.2)b 50,000,marginal benefit of effort,marginal cost,b$250,000,Mike Shor,15,(high low),Incentive Compatibility,Firm will put in high effort if,b$250,000,To maximize profit,set b as low as possible,b=$250,000,Next,solve participation constraint,Mike Shor,16,Participation,The,total,compensation should be good enough for the firm to accept the job.,Want firm to prefer high effort to none.,The firm will accept the job if:,f+(0.8)b-150,000 0,Mike Shor,17,(high none),Participation,Firm will accept contract if expected pay is greater than cost,f+(0.8)b 150,000,Solution,Substitute minimum bonus:,f+(0.8)250,000$150,000,f+$200,000$150,000,f$50,000,Mike Shor,18,Negative Fixed Payment?,Certainly not for normal employees,Ante in gambling,Law firms/partnerships,Work bonds/construction,Startup funds,Interpretation:,Capital the firm must put up for the project,Fine the firm must pay if the project fails
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