Islam Syed Nazrul

ID # 09FD952

Q. Explain the constraint cannot hold when b≥ 1, in Principal-Agent Relationship.

We have the constraint for maximization of Principal’s expected profit under

Principal-Agent Relationship as-

E(u’)(1-b)/R+E(u’ε ) =0 …. (i)

If b≥ 1, the first term in equation (i), E(u’)(1-b)/R, is negative. The second term,
E(u’ε ), is also negative since E(u’ε ) is the covariance between u’ and ε (note that
E(ε)=0). The reason for the covariance is negative that, if b≥ 1,

As ε increases => Π (= e+ε ) increases.

Hence, the agent’s income [wage, w= a + b (e+ε) ] is an increasing function of ε.

So, the marginal utility, u’, which is a decreasing function of wage, is non-increasing
in ε.

Therefore, the constraint (i) does not hold when b≥ 1.

We have, w=a +b (Π) = a + b (e+ε)

It means that if b=1, the agent is the residual claimant of the profit; if b>1, the
agent gets more than the profit and the Principal become worse off. So the contract
would not be efficient and does not work.

Thus, as the agent is risk averse the utility curve is concave where u’>0 and u”<0.
And, the b lies between 0 and 1.