An Analysis of the Principal-Agent Problem

Abstract

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.Most analyses of the principal-agent problem assume that the principal chooses an incentive scheme to maximize expected utility subject to the agent's utility being at a stationary point. An important paper of Mirrlees has shown that this approach is generally invalid. We present an alternative procedure. If the agent's preferences over income lotteries are independent of action, we show that the optimal way of implementing an action by the agent can be found by solving a convex programming problem. We use this to characterize the optimal incentive scheme and to analyze the determinants of the seriousness of an incentive problem. 'Support from the U.K. Social Science Research Council and NSF Grant No. SOC70-13429 is gratefully acknowledged. We would like to thank Bengt Holmstrom, Mark Machina, Andreu Mas-Colell, and Jim Mirrlees for helpful comments. 2These and other applications are discussed in a number of recent papers. See, for example, Harris and Raviv [6], Holmstrom [7], Mirrlees [10, 11, 12], Radner [15], Ross [17], Rubinstein and Yaari [18], Shavell [19, 20], Spence and Zeckhauser [21], Stiglitz [22], and Zeckhauser [24]. 7 This content downloaded from 128.210.126.199 on Fri, 19 Jun 2015 11:53:54 UTC All use subject to JSTOR Terms and Conditions 3The reason for this can be seen quite easily in Figure 1 (we are grateful to Andreu Mas-Colell for suggesting the use of this figure). On the horizontal axis, I represents the agent's incentive scheme and on the vertical axis a represents the agent's action. The curve ABCDE is the locus of pairs of actions and incentive schemes which satisfy the agent's first order conditions, i.e., given I the agent's utility is at a stationary point. Of these points, only those lying on the segments AB and DE represent global maxima for the agent, e.g. given the incentive scheme I the agent's optimal action is at P', not at P2 or p3. Indifference curves-in terms of a and I-are drawn for the principal (C is on a higher curve than B). The true feasible set for the principal are the segments AB and DE and the optimal outcome for the principal is therefore B. However, B does not satisfy the first order conditions of the problem: maximize the principal's utility subject to (a, I) lying on ABCDE, i.e., subject to (a, I) satisfying the agent's first order conditions (the solution to this problem is at C). In other words, B does not satisfy the necessary conditions for optimality of the problem which has been studied in much of the literature. Note finally that perturbing Figure 1 slightly does not alter this conclusion. This content downloaded from 128.210.126.199 on Fri, 19 Jun 2015 11:53:54 UTC All use subject to JSTOR Terms and Conditions PRINCIPAL-A...

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