Lecture 1 - The Principal-Agent Model

Behavioural Economics of Organisations
Lecture 1 – The Principal-Agent Problem
Winter 2023-24
Introduction
What is Behavioural Organisational Economics?
→ Application of behavioural economics to organisations
→ Definition by Colin F. Camerer and Ulrike Malmendier (2007):

Introduction
• Behavioural Economics modifies the standard economic model

• Accounts for psychological factors that affect preferences and judgment
• Which creates limits on rational calculation, willpower and greed
• Resulting behavioural economic models provide parsimonious and psychologically sound

explanations for empirical findings that the standard model cannot explain
Introduction
• From a methodological perspective: Behavioural Economics is a humble approach to economics,

which respects the comparative empirical advantages of neighbouring social sciences
• Thinking about organisations extends the definition of behavioural economics to include how
socialisation, networks, and identity shape individual behaviour in organisations
Introduction
• Systematic biases in individuals’ behaviour in firms – if workers misallocate their human capital –
can have large and persistent impact on decision-making in organisations
• How should organisations be designed to exploit – or correct – mistakes that stem from these
biases?
• A lot of psychology is involved when workers team up in organisations:
social comparison, changes in identity, attribution and diffusion of credit and blame,…
• (For more on this, see Camerer, Colin F., and Ulrike Malmendier, 2007. "Behavioral Organizational Economics." In Peter
Diamond and Hannu Vartiainen, eds., Behavioral Economics and Its Applications. Princeton University Press. Pages 235-
290)
Introduction
→ Application of behavioural economics to organisations in the form of personnel economics
→ Definition by Peter Kuhn (2018):
→ Study the selection and motivation of employees
6 KING’S BUSINESS SCHOOL | kcl.ac.uk/business

Introduction
Under selection, we study….
How to pick the ‘right’ people from a pool of applicants (screening, references,
interviews):
Assembling an applicant pool:
• where (how broadly) to search
• how long to search (vacancy duration)
• designing job ads and/or application forms
• how much to use networks and referrals (informal search)

Introduction
But also: Attracting an applicant pool:

• setting pay/benefits/duties
• structuring pay/benefits/duties
• acquiring a reputation as an employer

Introduction
Retention:
• setting the level of pay, benefits, duties, training
• creating an employer reputation
• structuring pay/benefits/duties
• offer matching policy
• evaluation, dismissal, layoff, leave policy

Introduction
Motivation means inducing workers to internalise the goals of the enterprise
In addition to explicit monetary incentives (“variable pay”), motivation includes:

• harnessing intrinsic motivation
• harnessing/being aware of behavioural biases (e.g. framing, reference points)
• setting overall pay generosity and dismissal policy
• wage fairness and inter-worker comparisons
• managing competition among workers (when to use tournaments; how to structure them)
• inducing (the right kind of) cooperation among workers (team production and team-based pay)

Introduction
Personnel Economics is almost never about maximising profits at workers’ expense, for at
least two reasons:
1.
Good personnel policies in this module are defined as ‘win-win’ policies that make the pie bigger
→ We will try to identify policies that can make both firms and workers better off
→ ‘Good’ policies are Pareto-improving, Pareto-optimal, surplus-maximising, and socially efficient

Introduction
Personnel Economics is almost never about maximising profits at workers’ expense, for at
least two reasons:
2.
Because there is a labour market, even an employer who cares only about their own profits cannot
treat workers arbitrarily badly. Why?
→ In many cases the fact that workers have outside options can force even purely selfish employers to
design Pareto-optimal personnel policies
Incorporating the constraints played by labour markets into the study of HRM is a key contribution
of personnel economics, relative to some other disciplines’ approaches

Introduction
Why is Personnel Economics Important?
1. The exchange of effort for pay is probably the most important economic transaction in the
economy, and certainly in most peoples’ lives
2. The best way to structure these transactions is not at all obvious. We’ll show that two extreme
views:
• workers are inherently lazy and stronger financial incentives are always better than weaker ones
• workers are inherently good and will do what is needed with a minimum of financial incentives
can both lead to really bad results

Introduction
Why is Personnel Economics Important?
3. Effective Human Resource Management (HRM) can be highly profitable, and can make workers’
lives much better too:
We’ll look at a number of case studies which show that simple, correctly-targeted HRM
innovations can yield gains that compare very favourably with the best technological innovations
(In fact, the two often go hand-in-hand)

Introduction
So, where should we start?
• We’ll begin on the motivation side, and by doing some theory

• Specifically, we’ll study the simplest possible theoretical model of the optimal design of financial
incentives—i.e. the principal-agent model
• To motivate this model, imagine you have just been seriously injured in an accident in one of the
big box stores. You need to hire a lawyer to sue the store for damages.
• How should you pay this person?

Structure of the Principal-Agent Problem
Timeline of Actions in the Principal–Agent Problem
(Figure 1.1, Personnel Economics, 1e, Peter Kuhn Copyright © 2018 Oxford University Press)

Essentially, there are two key stages:

1. The principal (or the principal and agent together) set the “rules of the game” or contract. These
rules must be acceptable to the agent, or they won’t work for the principal.
2. The agent maximises his own utility, taking the contract/rules as given, and payments are made.
Solution Method (Backwards Induction):

1. Figure out what the agent is going to do under a set of rules:
(i.e., find the agent’s “reaction function”).
2. Solve for the optimal contract/rules given the agent’s expected response.

Our Example:
• One principal, one agent, no uncertainty
• One output (𝑄), observed by principal and agent. 𝑄 is dollars of net revenue.
• Principal can’t observe effort (𝐸) (so we can’t base the contract directly on it).
• The production function: 𝑄 = 𝑑𝐸
𝑑 > 0 is a productivity parameter that can capture ability or technology differences

Our Example:
• Much of the time, we’ll use our baseline production function :
𝑄 = 𝐸
When we use this function, we are measuring effort in terms of the amount of output it yields,
i.e. one unit of effort is ‘what it takes’ to produce one unit of output.

• The agent’s utility is:

𝑈 =𝑌−𝑉 𝐸 (1)
where 𝑌 is income and 𝑉 is the cost of effort.
• We assume increasing marginal costs of effort, i.e. 𝑉′ > 0 and 𝑉″ > 0

• Cost of effort function:
• Much of the time, we will use this baseline cost-of-effort function:

𝐸2
𝑉 𝐸 = 2
2

• The utility function (1) can be represented by an indifference map, which looks like this:
• Re-arranging equation (1), the equation for an indifference

𝐸2
curve is just 𝑌 = 𝑈 + 𝑉(𝐸), or 𝑌 = 𝑈 + .
2
• For any given effort level, 𝐸, the indifference curve tells us

how much we must pay the agent (𝑌) to give them a utility
level of 𝑈.
• The slope of every indifference curve is 𝑑𝑌/𝑑𝐸 = 𝑉′(𝐸),
which is increasing in 𝐸.

• In general, the contract between the principal and agent can be any relationship between what the
principal observes (in this case 𝑄) and what the agent is paid (𝑌).
• In today’s example, we will restrict our attention to linear piece rate contracts,
i.e. to contracts of the form 𝑌 = 𝑎 + 𝑏𝑄:
→ The “contract” is an ordered pair, (𝑎, 𝑏), where 𝑎 is base pay and 𝑏 is the “piece rate” (again, per
dollar of net revenue generated by the agent’s effort).
(From Instructors’ resources, Personnel Economics, 1e, Peter Kuhn Copyright © 2018 Oxford University Press)

• Finally, we assume the agent’s alternative utility is 𝑈 𝑎𝑙𝑡 .

• Thus, the agent’s participation constraint can be expressed as:
𝑈 ≥ 𝑈 𝑎𝑙𝑡
This participation constraint can be interpreted in two ways:

1. Literally: In order to maximise profits, an employer knows 𝑈 𝑎𝑙𝑡 and wants to offer the agent the
lowest possible utility that induces the agent to accept the contract,
i.e. a contract that leaves the agent indifferent between accepting or not.
2. As a mathematical device for finding any Pareto-optimal contract:
First, choose how well off you want the agent to be. Then make yourself as well off as possible.

Solving the Agent’s Problem
• (Assuming a linear contract (𝑎, 𝑏), and using our baseline production- and cost-of-effort functions)
Given (𝑎, 𝑏), max 𝑈 = 𝑌 − 𝑉(𝐸)

𝐸,𝑄,𝑌
subject to: 𝑌 = 𝑎 + 𝑏𝑄,
and to 𝑄 = 𝐸

• Substituting the two constraints (and the baseline effort-cost function) into the maximand, this is
equivalent to:
max 𝑈 = 𝑎 + 𝑏𝐸 − 𝐸 2 /2
𝐸
• The first-order condition (FOC) for a maximum is:

𝜕𝑈
=𝑏−𝐸 =0
𝜕𝐸
• Solving this for the effort level the agent will choose, yields:
𝐸∗ = 𝑏
• So, a higher commission rate (𝑏) induces higher effort.
Changing base pay (𝑎) has no effect on effort.

Agent’s Problem with Graphs A:
• By definition, E* maximises the difference between Y and V(E)

(part a).
• At E*, the marginal benefit of effort, b, just equals the

marginal cost of effort, V′(E) (part b).
• You can also see this in part a, where the slope of the V(E)
curve just equals the slope of the pay schedule (b) at E*.

Agent’s Problem with Graphs B:
The optimal effort level E* is where the budget

constraint (𝑌 = 𝑎 + 𝑏𝑄) is just tangent to the highest
indifference curve attainable.
At that point the slope of both curves equals 𝑏
(and therefore 𝑉′(𝐸) = 𝑏).
(Figure 2.3, Personnel Economics, 1e, Peter Kuhn Copyright © 2018 Oxford
University Press)

Summing up our results for the agent’s problem:
Result 2.1: Agents’ reactions to changes in the employment contract (𝒂, 𝒃) and
productivity (d):
1. For any given contract, more productive agents (with higher 𝑑) will work harder than less
productive agents.
2. Raising the slope parameter (𝑏) of the employment contract will make the agent work harder.
3. Changing the intercept parameter (𝑎) of the employment contract will have no effect on the
agent’s optimal effort level.

Summing up our results for the agent’s problem:
Result 2.2: Agents’ reactions to changes in the employment contract (𝒂, 𝒃) with the
𝑬𝟐
baseline production and cost-of-effort functions (𝑽 𝑬 = and d = 1):
𝟐
1. The agent’s optimal effort, 𝐸, now equals 𝑏 exactly (𝐸 = 𝑏).

Therefore, it’s still true that:
2. Raising the slope parameter (𝑏) of the employment contract will make the agent work harder.
3. Changing the intercept parameter (𝑎) of the employment contract will have no effect on the
agent’s optimal effort.

Solving the Principal’s Problem
The Principal’s problem is to figure out:

• how high a commission rate (𝑏) to pay the agent, and
• how much to pay the agent to show up (𝑎),
so as to maximise profits.

Before doing the full-blown principal’s problem, we’ll do a simpler, “warm-up” problem first.
As it turns out, this “warm-up” problem is the way most people think about the P-A problem when
they first encounter it.
It gives the wrong answer to the P-A problem. But we’ll learn some useful things from this mistake.
Note: We’ll stick to the baseline production and utility functions for the rest of this chapter.

The Warm-up Problem: Maximising profits when 𝒂 = 𝟎

(This seems like the right thing to do, since we’ve already proved that raising 𝑎 doesn’t elicit any
additional effort.)
Mathematically, we want to solve:

max Π = 𝐸 − (𝑎 + 𝑏𝐸)
𝑏
Subject to the agent’s incentive-compatibility constraint, 𝐸 = 𝑏.
(We’ll ignore the agent’s participation constraint in this warm-up problem by assuming that the
principal’s most preferred contract turns out to be acceptable to the agent).

Substituting the agent’s response to the contract, 𝐸 = 𝑏, into the definition of profits yields:
max Π = 𝑏 − 𝑎 + 𝑏2 = 𝑏 − 𝑏 2 − 𝑎 = 𝑏 − 𝑏 2
𝑏
The first-order condition (FOC) for a maximum is:

𝜕Π
= 1 − 2𝑏 (SOC for a maximum is fulfilled, too)
𝜕𝑏
Thus, 𝑏 ∗ = 0.5
⟹ a 50% (of net revenues generated by the agent) commission rate maximises profits in this
situation.
34 KING’S BUSINESS SCHOL | kcl.ac.uk/business

To see why, consider a graphical solution:
At the profit-maximising contract:

• Agent’s effort level will be: 𝐸 = 𝑏 = 0.5
• (Using the production function) output will be: 𝑄 = 𝐸 = 0.5
• Profits will be: Π = 𝑄 – 𝑎 − 𝑏 ∗ 𝐸 = .5 – 0 − .5 ∗ .5 = .25
𝐸2 𝐸2 𝑏2 𝑏2 .52
• Agent’s utility will be: 𝑌 − = 𝑏𝐸 − = 𝑏2 − = = = .125
2 2 2 2 2

More generally:
• More generally (beyond the baseline production and utility functions):
the profit-maximising 𝒃 is always strictly between zero and 1 for any production and
utility function.
Why:
• 𝑏 = 0 yields no profits because the agent does nothing
• 𝑏 = 1 yields no profits (despite high effort) because it gives all the profits away.
• Thus, in this warm-up problem, the profit-maximising commission rate trades off two competing
goals:
• -incentives (higher 𝑏 raises effort)
• -distribution (higher 𝑏 redistributes income from the principal to the agent).

A final thing to notice about our ‘warm-up’ solution to the P-A problem:
Imagine we implement the suggested solution by setting 𝑏 = .5, then ask:

How would the principal and agent feel about raising 𝑏 a little bit?
(Figures 3.1 and 3.2, Personnel Economics, 1e, Peter Kuhn Copyright © 2018 Oxford University Press)

A final thing to notice about our ‘warm-up’ solution to the P-A problem:
• Principal wouldn’t mind very much (because profits are a relatively flat function of b at 𝑏 = .5)
• Agent would like it a lot, (utility is convexly increasing in 𝑏)
Thus, starting at 𝑏 = .5, a small increase in 𝑏 benefits the worker but doesn’t really hurt the firm.
This suggests that efficiency might be improved by raising 𝒃 beyond . 𝟓….

The ACTUAL Principal’s Problem
Mathematically, we want to solve:

max Π = 𝐸 − (𝑎 + 𝑏𝐸)
𝑎,𝑏
Subject to the agent’s incentive-compatibility constraint, 𝐸 = 𝑏
and to the agent’s participation constraint, 𝑈 ≥ 𝑈 𝑎𝑙𝑡

(we’ll assume this is satisfied with equality, 𝑈 = 𝑈 𝑎𝑙𝑡 ).

STEP 1: Characterise the participation constraint,

i.e. find the level of 𝑎 needed to reach a utility level of 𝑈 𝑎𝑙𝑡
(assuming the agent maximises his utility subject to any contract they faces).
To do this, recall that:
𝑈 =𝑌−𝑉 𝐸
= 𝑎 + 𝑏𝐸 − 𝐸 2 Τ2
= 𝑎 + 𝑏 2 − 𝑏 2 /2
= 𝑎 + 𝑏 2 /2
𝑎𝑙𝑡 𝑎𝑙𝑡 𝑏2
Rearranging and setting 𝑈 = 𝑈 gives 𝑎=𝑈 − (1)
2

STEP 1:
𝑏2
𝑎= 𝑈 𝑎𝑙𝑡 − (1)
2
If the agent always chooses their effort to maximise their utility (taking 𝑏 as given), equation (1) tells us
how much base pay (𝑎) we need to give the agent so they’ll attain the ‘target’ utility of exactly 𝑈 𝑎𝑙𝑡 .
The better off we want the agent to be (i.e. the higher a 𝑈 𝑎𝑙𝑡 we want to achieve), the higher we need to
set 𝑎.
However, since 𝑎 and 𝑏 are alternative ways to make the agent better off, when 𝑏 is higher we don’t need
to give the agent as much 𝑎 to attain the same level of utility.

STEP 2:
max 𝛱
𝑏
Subject to: 𝐸=𝑏 (incentive compatibility constraint)

and to: 𝑎 = 𝑈 𝑎𝑙𝑡 − 𝑏 2 /2 (participation constraint)
Π = 𝐸 − 𝑎 + 𝑏𝐸
= 𝑏 − 𝑎 + 𝑏2 (since 𝐸 = 𝑏)
= 𝑏 − 𝑈 𝑎𝑙𝑡 + 𝑏 2 /2 − 𝑏 2 (since 𝑎 = 𝑈 𝑎𝑙𝑡 − 𝑏 2 /2)
= 𝑏 − 𝑏 2 /2 − 𝑈 𝑎𝑙𝑡
𝜕Π
FOC for a maximum are: = 1 − 𝑏 = 0. (SOC is fulfilled, too)
𝜕𝑏
Therefore, 𝑏 ∗ = 1.

Graphically:

Thus, in the profit-maximising contract, the principal should set a commission rate of 100%;
i.e. the agent’s pay should rise by one dollar for every dollar the agent contributes to net revenue.
Notice that this result doesn’t depend on 𝑈 𝑎𝑙𝑡 , i.e. the level at which we choose to set the agent’s
utility.
It follows that a 100% commission rate is profit-maximising, regardless of how well off we want
the agent to be!

To sum up, let’s list the agent’s effort, output, utility, and the firm’s profits, etc. at two different
commission rates (50% and 100%), with 𝑎 set in both cases to guarantee the worker a utility level
(𝑈 𝑎𝑙𝑡 ) of 0.25:
(Table 3.1, Personnel Economics, 1e, Peter Kuhn Copyright © 2018 Oxford University Press)

To sum up:
We can make the principal better off without hurting the agent by switching from the
(a,b) = (1.25, .5) contract to the (a,b) = (-.25, 1) contract.

Lessons:
1. “Put the rewards where the decisions are made”.
When the agent controls a decision that affects the utilities of a larger group (in this case himself
plus the principal), it is profit maximising to have the agent bear all the costs, as well as all
the returns of his actions.
This result does not depend on the level of 𝑈 𝑎𝑙𝑡 —i.e on how well-off we want the agent to be.
2. When agents receive 100% of the fruits of their labour at the margin (𝑏 = 1), principals’ only
source of profits is from setting a negative level of base pay, 𝑎 (in other words by “selling the job
to the worker”).
⟹ Compared to the ‘warm-up’ problem: we can set b =1 to fully incentivise the agent, while a can be
used to achieve any feasible distributional outcome you like.

Is it Crazy to “sell the job to the worker”?
While this might seem strange at first, there are at least three distinct ways it actually occurs in
today’s economy.
1. Explicit payment for jobs: Can you think of any examples?
• Taxi drivers, hairdressers at booth rental salons, manicurists, Fedex Ground workers, real estate
agents (desk fee), stock traders at ‘prop’ firms, and…

Here are some links:

Angrist, Joshua, Sydnee Caldwell and Jonathan Hall, Uber vs. Taxi: A Driver's Eye View
Gentile, Marie. “How Does Commission Work at a Hair Salon?” Chron.com, 2016.
Nir Sarah Maslin.“The Price of Nice Nails” New York Times, May 7, 2015
Rooney, Ben. “The FedEx driver who sued and won” CNN Money, November 21, 2014:
Weintraub, Elizabeth. Desk Fees for Real Estate Agents thebalance.com, updated June 27, 2016
Kimmons, James. Methods of Compensating Real Estate Agents - Commissions and Splits. thebalance.com,
updated 19 September, 2022
Stock traders at proprietary (prop) firms may pay a desk fee, which can range from $200 to $4000 per month.

Many economists refer to the (𝑎 < 0, 𝑏 = 1) solution to the principal-agent problem as the
“franchise solution”.
Today, there are about 800,000 franchisees in the United States: www. statista.com,
Number of franchises has more than doubled in the last 25 years to 48,000 in the United Kingdom:
www.franchise-uk.co.uk

2. “Buy, don’t make.”

For agency problems that are this simple, the best solution may not be to hire a worker to provide
a product or service, but to buy the product or service from someone else.
Because that ‘someone’ is their own business, they bear 100% of the costs and rewards associated
with producing their product.

3. Implicit payment for jobs

In many cases, workers may be reluctant (for liquidity or trust reasons) to make a large up-front
payment for a job, even when that might be socially optimal.
For many workers receiving commission or other forms of performance-based pay, a solution is
to “build the entry fee into the worker’s pay schedule”:

To see how this can work let’s imagine a car salesperson who is paid on the basis of their monthly net
sales, 𝑄.
The profit-maximising solution to their

P-A problem is shown here:
• at 𝑄 ∗ , the worker’s indifference curve is
tangent to their budget constraint, 𝑌 = 𝑎 + 𝑄
• there, the income is less than they produce
(by – 𝑎, which is the fee for the job)
• profits are 𝑄 − 𝑌 = −𝑎, which is the vertical
distance shown.

But suppose our worker can’t afford to pay up front for the job.
Why not ‘take the entry fee in kind’ by just not paying them for the first n cars they sell each month?
More precisely, let’s replace the previous contract, 𝑌 = 𝑎 + 𝑄 by the contract in bold (see next slide):

• The new schedule sets 𝑌 = 0 when Q<Q0 and

Y = a+Q when Q≥ Q0.
• Now, 𝑌 ≥ 0 no matter how much the
worker produces.
• Worker’s optimal choice is still at Q*,
so Y, Q and Π are all unchanged.
• Essentially, the worker supplies 𝑄0 = −𝑎 units
of output free each month.

Now suppose our worker is still wary of a contract that doesn’t give them a positive level of base
pay they can rely on each month, regardless of how they perform.
Can we do that?
Consider the following contract:

• Workers who produce less than some threshold (let’s make it Q0 to avoid clutter) are dismissed
and earn zero.
• Workers who meet or beat that minimum standard qualify for a fixed positive base pay, or
‘draw’ D.
• To qualify for incentive pay (at a rate of b=1), a worker must sell at least Q1 > Q0.

More precisely, the new contract works like this:
If 𝑄 < 𝑄0, 𝑌 = 0
If 𝑄0 ≤ 𝑄 < 𝑄1, 𝑌 = 𝐷 > 0 (fixed base pay).
If 𝑄 ≥ 𝑄1, 𝑌 = 𝐷 + 𝑏(𝑄 − 𝑄1) where 𝑏 = 1. So the worker still collects their positive ‘draw’, and
earns a 100% commission only on units sold above Q1.

Diagrammatically:
This new schedule also yields exactly the same
output, profits and utility as the original one,
provided that D is not too generous.
What happens when D is too high?

If D is too high (or if Q0 is too low) point n will lie
above the indifference curve through point m.
What will the agent do then?

Summing up:
Incentive pay plans where:
• you get a fixed positive base pay as long as you keep your job
• but you have to sell a minimum amount to qualify for incentive pay
can deliver the exact same results as the superficially ‘extreme’ 𝑎 < 0, 𝑏 = 1 pay plans predicted by
our first principal-agent model.
-to accomplish this, the draw, D can’t be ‘too’ generous relative to output needed to keep your job, Q0.

Best for Whom? Efficiency and Distribution
Economically efficient contracts maximise the sum of the principal’s profits plus the agent’s
utility:
𝑊 = Π + 𝑈.
Alternative terms for 𝑊 include social welfare, social surplus, and the ‘size of the pie’ to be divided
between workers and firms.

To find the economically efficient contract, notice that 𝑊 can be written:

𝑊 = (𝑄 – 𝑌) + (𝑌 − 𝑉(𝐸)) , or just
𝑊 = 𝑄– 𝑉 𝐸 .
Thus, while payments from the firm to the agent (𝑌) make the firm worse off and the agent better off,
the total amount the firm pays the worker subtracts out of our definition of social
welfare.
That’s because raising or lowering 𝑌 just ‘moves money (or utility) around’ without affecting the total
amount of utility that is produced.
Once those transfers are netted out, social surplus that just equals the total amount
produced (Q), minus the cost of producing it (V(E)).

Problem 1:
Use the same steps as in the ‘warm-up problem’ to find the economically efficient contract under
our baseline assumptions. In other words, choose b to maximise Π + U, subject to the worker’s
incentive-compatibility constraint, to prove the following result:
Result 4.1: The Economically Efficient Contract

Just like the principal’s most preferred contract for a given worker utility (𝑈 𝑎𝑙𝑡 ), the economically
efficient contract (which maximises the sum of the principal’s profits plus the agent’s utility) has a
100% commission rate (𝑏 = 1).

Problem 2:
Parallel to what we did in the ACTUAL Principal’s Problem, find the contract (a, b) that maximises
the agent’s utility, subject to the incentive-compatibility constraint (𝐸 ∗ = 𝑏) and a participation
constraint for the principal: Π ≥ Π 𝑎𝑙𝑡 .
You’ll find that 𝑏 = 1 again.
[Solutions to Problem 1 and 2 will be discussed in first tutorial.]

Summing up:
The optimal contract between a principal and an agent has a 100% commission rate (b = 1)
regardless of whose welfare (the agent’s, the firm’s, or both) we want to maximise.
This is because it makes sense to maximise the size of the pie regardless of how we
ultimately decide to divide that pie.
Essentially, we maximise the pie by setting b = 1, then divide it up between the parties by picking a
level of 𝑎 that is acceptable to both parties.
For this reason, in most of this module we’ll focus our attention on finding economically efficient
contracts, i.e. contracts that maximise 𝑊 = Π + 𝑈.

Literature
• Camerer, Colin F., and Ulrike Malmendier, 2007. "Behavioral Organizational Economics." In
Peter Diamond and Hannu Vartiainen, eds., Behavioral Economics and Its Applications.
Princeton University Press. Pages 235-290.
• Kuhn, P. (2018). Personnel economics. Oxford University Press.

Preface
Chapters 1 – 4

Lecture 1 - The Principal-Agent Model

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Lecture 1 - The Principal-Agent Model

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Behavioural Economics of Organisations

Lecture 1 – The Principal-Agent Problem

What is Behavioural Organisational Economics?

→ Application of behavioural economics to organisations

→ Definition by Colin F. Camerer and Ulrike Malmendier (2007):

What is Behavioural Organisational Economics?

• Behavioural Economics modifies the standard economic model

• Resulting behavioural economic models provide parsimonious and psychologically sound

What is Behavioural Organisational Economics?

• From a methodological perspective: Behavioural Economics is a humble approach to economics,

What is Behavioural Organisational Economics?

What is Behavioural Organisational Economics?

→ Application of behavioural economics to organisations in the form of personnel economics

→ Definition by Peter Kuhn (2018):

→ Study the selection and motivation of employees

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Under selection, we study….

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Under selection, we study….

But also: Attracting an applicant pool:

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Under selection, we study….

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Motivation means inducing workers to internalise the goals of the enterprise

In addition to explicit monetary incentives (“variable pay”), motivation includes:

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Why is Personnel Economics Important?

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Why is Personnel Economics Important?

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So, where should we start?

• We’ll begin on the motivation side, and by doing some theory

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Timeline of Actions in the Principal–Agent Problem

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Essentially, there are two key stages:

Solution Method (Backwards Induction):

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• The agent’s utility is:

• We assume increasing marginal costs of effort, i.e. 𝑉′ > 0 and 𝑉″ > 0

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• Cost of effort function:

• Much of the time, we will use this baseline cost-of-effort function:

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• Re-arranging equation (1), the equation for an indifference

• For any given effort level, 𝐸, the indifference curve tells us

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• Finally, we assume the agent’s alternative utility is 𝑈 𝑎𝑙𝑡 .

This participation constraint can be interpreted in two ways:

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Given (𝑎, 𝑏), max 𝑈 = 𝑌 − 𝑉(𝐸)

subject to: 𝑌 = 𝑎 + 𝑏𝑄,

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• The first-order condition (FOC) for a maximum is:

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Agent’s Problem with Graphs A:

• By definition, E* maximises the difference between Y and V(E)

• At E*, the marginal benefit of effort, b, just equals the

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