Question #7

 Unit 6, 10, and ‘Economics of Projects’ lecture

 Principal/Agent problem and associated issues
o Include examples
 Relationship between incomplete contracts, hidden information, and hidden actions
 Need to talk about projects

 Principle/Agent problem and model

 Based in economic theory – popularised by Akerlof’s (1970) seminal work A Market
for Lemons (AKA the Lemon Problem)
 Asymmetry of information leads to the principal/agent problem
o Asymmetry of information: Agents will know more about relevant work than
principals, thus asymmetry. For complicated and complex projects this is a
major issue.
 Asymmetry of information and incentive conflicts leads to adverse selection and
moral hazard
o Incentive conflict: Principals want agents to work in their (the principals’)
best interests, but agents typically have their own interests and potentially
different goals than do principals
 Adverse Selection (hidden information, pre-contract)
o Hidden information: When one party has private information not known to
others
o Problems in procurement, i.e. bidding and tendering
 Moral Hazard (hidden action, post contract)
o hidden action problem occurs when:
 there is a conflict of interest between the principal and the agent
over some action that may be taken by the agent, and this action
cannot be subjected to a complete contract.
 The information about the action may be either asymmetric or
unverifiable
 Can generate adversarial behaviour and post contract opportunistic behaviour,
which can be lucrative
 3 Prime principle/agent examples in project
o Main: Procurement and tendering
 i.e. Client (principal) and supplier (agent)
o Within project-based firm with employment
 i.e. firm (principal) and employee (agent)
o Project finance and Lending
 i.e. lending bank (principal) and client (agent)
 Incomplete contracts
o Contracts for labour temporarily transfer authority over a person’s activities
from the employee to the manager or owner.
o Incomplete contract does not specify, in an enforceable way, every aspect of
the exchange that affects the interests of parties.
o Principal-agent models capture interactions under incomplete contracts
 Hidden action and hidden information
 o Contracts are often incomplete because:
 Information is unverifiable, relationships cover a period time (i.e.
can’t perfectly predict future), uncertainty, difficult measurements
 Techniques used to deal with incomplete contracts and principal agent problems
o Contract theory
 In an ideal world (though not possible) it is possible to write a
complete contract that induces the both principals and agents to take
the `right' actions in every possible state of world.
 This leads ex post to a Pareto efficient outcome
 Incentives
 Holmström: ‘informativeness principle’, an optimal contract
must include every possible factor that conveys meaningful
information about the employee’s effort
 Hart (1995) argues the level of specification of a project is the
determining factor in the type of contract that should be used
o 3 types: fixed price, cost plus, and incentive
 Meng and Gallagher (2012) show that, if used effectively,
incentive contracts can align project objectives between
different project actors and improve project performance,
especially if more than one incentive is used
 Control Rights:
 Hart: focused on the optimal allocation of control rights: which
party to the contract should be entitled to make decisions in
which circumstances? (especially relevant to strategic
alliances)
o Equity and collateral (for project finance)
o Procurement: Partnering, alliances, supply chain management (prime
contracting) (this is not from the lectures, but could apply)
o Employees (I don’t think this will be the focus of the question)
 Piece rate work = a type of employment in which the worker is paid a
fixed amount for each product made. (not very common)
 Reservation wage = value of next best option (other employment or
unemployment benefits)
 Employment rent = wage – reservation wage – disutility of
effort
 Employees fear getting fired when they are paid more than
their reservation option = they receive employment rent.
 Best response curve shows the optimal amount of effort
workers will exert for each wage offered (see below)
Maximum