This paper examines the challenges of contracting under imperfect information, with a focus on information asymmetry and agency problems. It explains how pre- and post-contractual information gaps create incentive conflicts between principals and agents, and why these conflicts are costly to resolve. Using a manufacturing firm seeking legal services as a practical example, the paper applies marginal cost and marginal benefit analysis to determine the value-maximizing level of service and demonstrates how monitoring costs, bonding costs, and residual losses reduce the total surplus available to contracting parties. The paper concludes that incomplete contracts are a rational response to the high costs of full contractual specification.
Well-designed contracts can typically resolve incentive problems at a low cost. However, contracts often fail to accomplish this objective. In practice, contracts tend to be costly to negotiate, write, administer, and enforce. One of the factors that most significantly limits a contract's ability to resolve incentive conflicts is costly information. Information asymmetry occurs when one party — the seller or the buyer — knows more about the profits or value at stake than the other, allowing that party to take advantage of its informational advantage. 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 a customer's consumption perk requires a compensation contract. Designing that contract requires perfect information regarding the firm's potential profit, which is often infeasible.
The general information problems arising in contracting fall into two categories: information asymmetries that exist before contract negotiation, and information asymmetries that emerge during implementation. Information problems that arise after contract negotiation most commonly take the form of agency problems. An agency relationship is one in which one party — the principal — engages a second party, the agent, to perform various tasks on the principal's behalf. For example, shareholders within a corporation may appoint a board of directors to oversee management. Much of the operating authority is then delegated by the board to senior executives, who in turn assign tasks to employees at lower levels within the corporation.
The incentives of agents and principals are rarely automatically aligned, which gives rise to agency problems. Once a contract is in place, agents have an incentive to take actions that increase their own well-being at the principal's expense. Asymmetric or imperfect information typically precludes a costless resolution of such contracting problems. The principal cannot necessarily observe every action of the agent without cost, which gives the agent an opportunity to engage in perk consumption without those actions being invariably detected (Brickley, Smith & Zimmerman, 2015).
The principal can, however, limit such behavior by establishing appropriate incentives for the agent and by incurring monitoring and contract costs. Agents may also incur bonding costs — expenditures that guarantee they will not take actions at the principal's expense, or that ensure the principal is appropriately compensated should they do so. Agents show their willingness to incur such expenses because doing so increases the amount the principal is willing to pay for their services. If controlling contracting problems is itself costly, it generally does not pay for either party to incur sufficient costs to guarantee that the agent completely follows the principal's wishes.
At some point, the marginal cost (MC) of any additional expenditure to increase agent compliance exceeds the marginal benefit (MB) of that compliance (Brickley, Smith & Zimmerman, 2015). The concept of agency costs encompasses the monitoring expenditures of the principal, the bonding expenditures of the agent, and the residual loss — the remaining welfare reduction that persists even after optimal monitoring and bonding. Principals and agents must therefore balance the costs of controlling incentive problems against the gains from doing so.
To illustrate the concepts of agency cost and information asymmetry, consider a manufacturing firm that seeks legal help from a law firm. The marginal benefit to the manufacturing firm is given by MB = $400 − 2L, where L represents the hours per week of legal services provided. The marginal cost to the law firm for providing those services is assumed to be constant at $200 per hour.
"Solving for optimal legal service hours using MB and MC"
"How contracting costs and residual loss reduce total surplus"
If the planning, negotiation, writing, and enforcement of contracts were costless, it would be straightforward to purchase services from an outside supplier, as the terms would not necessarily matter. However, contracting is often very costly, in part because it is difficult to anticipate and plan for every possible contingency, and in part because negotiating and enforcing agreements can be expensive. Contracting costs therefore make incomplete contracts rational: parties deliberately omit provisions for certain contingencies rather than bear the cost of specifying them fully, leaving those matters to future negotiation.
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