Running head: CONTRACTING WITH IMPERFECT INFORMATION
5
CONTRACTING WITH IMPERFECT INFORMATION
Contracting with Imperfect Information
Usually, contracts that are well designed can resolve issues such as incentive problems at a low cost. However, contracts often fail in accomplishing this objective. Also, contracts in practice tend to be costly for negotiation, writing, administration, and enforcement. One of the factors that significantly limits the ability of a contract to resolve any incentive conflict is costly information. Information is asymmetric, where the seller or the buyer knows more about the profits than the other party, taking advantage of the other party. For instance, the seller may be more aware of the potential profit and the consumers perk consumption (Brickley, Smith & Zimmerman, 2015). Given such a distribution of information, controlling the customers consumption perk takes a compensation contract. This needs perfect information regarding the firms potential profit becomes infeasible.
The general information problems arising in contracting are information asymmetries that result before the negotiation of the contract and information asymmetries that occur during the implementation process of the contract. Information problems that take place after the contract negotiation that might arise include agency problems. An agency relationship is one in which one party, usually the principal, engages the second party, in this case, the agent, to perform various tasks on the principals behalf. For example, shareholders within a corporation can appoint a board of directors to help them oversee the corporations management. Much of the operating authority is delegated to the senior executives by the board, who then assign the necessary tasks to the employees in the lower levels within the corporation.
Usually, the incentives of the agents and the principal fail to be automatically aligned, which results in agency problems. This means that agents have the incentive to partake in actions to increase their well-being at the principals expense after the contract is set. Typically, asymmetric or imperfect information precludes the costless resolution of such contracting problems. The principal cannot necessarily observe every action of the agent costless. This gives the agent the chance to take perk consumption without the same actions invariably being detected by the principal (Brickley, Smith & Zimmerman, 2015).
Nonetheless, the principal can limit such
…problem or where information is costless.
The manufacturing firm is unwilling to pay as much for the anticipated fewer hours as if it got 100 hours of legal services. The second graph illustrates this outcome. The triangle represents the residual loss which is the lost surplus resulting from the inefficiency to solve the incentive problem completely. Additionally, the two firms each cater for the monitoring and bonding costs which further reduce the surplus as shown by rectangle 0. Therefore, the remaining surplus will equal the original surplus minus the total contracting cost (the total out-of-pocket costs and the residual costs). In the end, both firms will have made net benefits placing them in a far much better position than when there are no incentive problems or information asymmetry (Brickley, Smith & Zimmerman, 2015).
