Imperfect Information and Legal Contract

Running head: CONTRACTING WITH IMPERFECT INFORMATION

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 consumer’s perk consumption (Brickley, Smith & Zimmerman, 2015). Given such a distribution of information, controlling the customer’s consumption perk takes a compensation contract. This needs perfect information regarding the firm’s 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 principal’s behalf. For example, shareholders within a corporation can appoint a board of directors to help them oversee the corporation’s 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 principal’s 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 behavior by establishing appropriate incentives for the agent by incurring monitoring and contract costs. Agents can also incur bonding costs that guarantee that they don’t take any action at the principal’s expense or by ensuring that the principal is duly compensated should they do so. The agent, therefore, shows their willingness to pay to incur such expenses to increase the amount paid by the principal to the agent for the agent’s services. If controlling such contracting problems is costly, it generally doesn’t pay for either of the parties involved to incur sufficient costs to guarantee that the agent completely follows the principal’s wishes.

At some points, the marginal cost (MC) exceeds the marginal benefits (MB) of any additional expenditure to increase compliance (Brickley, Smith & Zimmerman, 2015). To illustrate the concept of agency cost and information asymmetry, a manufacturing firm is taken into consideration. The firm seeks some legal help from a law firm. The marginal benefits for this firm are given by MB= $400- 2L, where L represents the hours per week of the legal services offered. The marginal cost to the law firm for the provision of the required services is also assumed to be constant and is equal to $200 per hour.

Solution

The manufacturing firm’s marginal benefit, MB, for the legal services to be rendered is MB= $400- 2L, where L represents the hours per week of the legal services rendered to the manufacturing firm. The marginal benefits for the legal services to be rendered will be quite high for the first few hours. However, as the significant issues are resolved, the manufacturing firm will receive advice on successive issues that are less important. As a result, the marginal benefit of the additional or the extra hours of the legal services will decline with the number of hours of service provision. Moreover, the manufacturing firm’s marginal cost (MC) for providing the additional or extra hours of the legal services is assumed to be constant and equal to $200 per hour. The following equation gives this;

MC= $200

Value maximization for the manufacturing firm (where all potential gains are realized) occurs when the marginal cost equals the marginal benefits. The following equation represents this.

MB=MC

400-2L= 200

L= 100 hours

The values generated would not be optimal to provide over 100 hours of legal services to the manufacturing firm since the marginal benefits would be lower than the marginal costs. Furthermore, it would be suboptimal to render less than 100 hours of the legal services since the marginal costs resulting from the provision of the additional hours would be less than the marginal benefits. Assuming there are no contracting costs, an optimal contract between the manufacturing firm and the legal firm might specify 100 hours per week of legal services provided. For instance, the manufacturing firm could pay the legal firm $25,000 a week for the 100 hours of legal service provision. This outcome has been generated by the left panel of the figure below.

The total gain will be obtained as $10,000, as illustrated by the triangular part. Therefore, at $12,500 for the legal services rendered, the gains will be split between the manufacturing and legal firms. The fee covers the law firm’s costs of $20,000 (100*$200) and provides it with a profit of $5,000. The manufacturing company, on the other hand, receives gross benefits of $30,000. However, it pays a fee of $25,000 and therefore receives net benefits of $5000. If the manufacturing firm and the legal firm were to negotiate other prices for the 100 hours of the legal services rendered, the gains would be split differently.

Also, if the legal services market is perfectly competitive, the price would be $20,000, $200 per hour. Therefore, every gain would go to the manufacturing company. However, as long as the hours are set at 100, the agreement is considered efficient, and the total surplus is $10,000. Looking at the generated values, a potential incentive problem can misperceive this relationship. This is because it would be costly for the manufacturing firm to observe the legal firm’s hours of legal work since there is information asymmetry. Thus, the legal firm might work for less than 100 hours but claim it worked for the whole amount (Brickley, Smith & Zimmerman, 2015). The problem might be so severe and might result in the manufacturing firm not hiring the legal firm. If this happens, then the total potential gain from the relationship is lost. This becomes the residual loss.

Generally, the two firms can promote a mutually advantageous exchange by ensuring total control of the mentioned incentive problem through expenditures on bonding and monitoring. The manufacturing firm could spend a certain amount on monitoring the legal firm. The legal firm can also spend a certain amount per week documenting that it conducts or renders legal services to the manufacturing firm. The legal firm might provide fewer hours than the initial 100 hours of legal service, but in a real sense, more than if there is no monitoring or bonding and bills for 100 hours. Each party anticipates that this outcome might negotiate a different price for the legal service. However, this price is lower than when there is no incentive problem or where information is costless.