Unit 10 Market successes and failures: The societal effects of private decisions

10.8 Asymmetric information: Principal–agent relationships, hidden actions, and incomplete contracts

asymmetric information, asymmetry of information

Information that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.

incomplete contract

A contract that does not specify, in a way that can be enforced by a court, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

When we examine cases in which the market system fails to allocate resources efficiently, we often find an asymmetry of information at the root of the problem. If information about something that affects the value of a market transaction is not observable by both parties, and verifiable by a court, then it cannot be included in the contract governing the transaction. We have a problem of incomplete contracts.

conflict of interest

The situation that arises in an economic interaction if in order for one party to gain more, another party must do less well.

moral hazard, hidden actions

If there is a conflict of interest between a principal and an agent over the agent taking some action that cannot be observed or cannot be verified by a court, then the principal faces a problem of hidden actions; also known as moral hazard.

Unit 6 describes the principal–agent relationship between an employer (the principal) and employee (agent). There is a conflict of interest: the employer would like the employee to work hard; the employee prefers not to. The problem of asymmetric (or non-verifiable) information is that the employer (or at least the court) cannot observe or measure the employee’s work effort, so the required effort level cannot be included in the employment contract. A similar example, discussed in Unit 9 is the relationship between a lender and a borrower. The lender (principal) cannot tell whether a borrower (agent) is using a loan wisely, so that it can be repaid on time.

These are examples of a general class of principal–agent models, called hidden-action problems, in which an action taken by the agent is ‘hidden’ from the principal, or ‘unobservable’, leading to a problem sometimes called a moral hazard.

Hidden-action problems arise in many economic relationships, wherever:

• there is an action that benefits the principal, but is costly or difficult for the agent (hence a conflict of interest), and
• the action cannot be specified in a contract, because information about it is either asymmetric (the agent knows what action is taken, but the principal doesn’t) or unverifiable (it cannot be used by a court to enforce a contract).

Such problems arise particularly in relationships that last for a period of time after the contract (formal or informal) is agreed, where there is uncertainty about things other than the agent’s action that may affect the value of the relationship to the principal. For example, the insurance company cannot tell whether the car was stolen because the owner failed to lock it, or because they were unlucky enough to be targeted by an expert thief. Similarly, profits may be low for reasons other than the manager’s efforts, and an unemployed worker who remains unemployed may have been unlucky or not trying.

Hidden-action problems generally result in an inefficient allocation of resources. If the principal can give the agent an incentive to behave in the principal’s interest, this may be a partial solution. In the labour discipline model in Unit 6, the employer pays a wage above the reservation wage to provide an incentive for effort. The worker then exerts effort to avoid being caught shirking and fired. But the resulting allocation is not Pareto efficient: wages above the reservation level lead to a labour market outcome in which some workers are involuntarily unemployed (Section 6.11). In Unit 9, the hidden-action problem between borrower and lender results in some people who wish to borrow facing credit constraints or exclusion from the credit market.