Principal-agent Model Research Articles

Manipulative overconfidence and the cost of unbiased reporting

I study earnings management in a principal-agent model where the agent is overconfident in their ability to manage earnings, and the principal may induce the agent to communicate earnings truthfully. Without communication, overconfidence causes an increase in earnings management and incentive pay and may lead to a Pareto decrease in social welfare. Through communication, the principal can deter earnings management, and overconfidence increases the agent's total compensation at the expense of firm value. When the agent becomes significantly overconfident, communication loses value, and this causes a spike in earnings management.

Insurance Contracting with Adverse Selection and Moral Hazard

Most of the previous research in the asymmetric information problem treats adverse selection and moral hazard separately, though they may coexist and interact with each other. We build a principal-agent model to examine optimal contracts in a competitive insurance market facing adverse selection and moral hazard simultaneously. We apply the change-of-variable method and the Kuhn-Tucker conditions to solve the optimization programs. Our model yields richer separating Nash equilibria than pure moral hazard and pure adverse selection models, although separating Nash equilibria may not exist in some cases. It also retains some properties, for example, no full insurance and the positive correlation between insurance coverage and risk type, in those benchmark models. Our study on comparative statics indicates that, under some conditions and with some exceptions, the optimal indemnity and premium decrease with disutility from effort, increase with potential loss, and decrease with the initial wealth of the insured.

Is telemedicine worth the effort? A study on the impact of effort cost on healthcare platform with heterogeneous preferences

Telemedicine involves remote delivery of healthcare and virtual meetings between patients and doctors. However, its implementation in a traditional hospital can incur extra costs stemming from additional staffing, training, and IT infrastructure requirements. The effort needed by a doctor to treat a patient can be different depending on the mode of treatment. A principal-agent model is developed to find the optimal policy for both the agent (service provider, such as doctors) and the principal (platform, such as a hospital). We assume there are two types of service options, and the doctor prefers the service type with the lower effort cost. If the doctor’s policy is to accept both types of service options, her revenue may increase or decrease with an increase in the arrival rate of the less preferred service option. Offering only the service option with the higher average revenue is preferred if the service model is under the full control of the hospital. More importantly, the doctor and the hospital may not choose the same optimal strategies for certain values of effort costs. We show that this incentive misalignment issue can be solved by offering extra compensation for the less preferred service type of the doctor, which in turn affects the doctor’s strategy as well as the hospital’s rewards. Our study contributes to the literature on service queues with heterogeneous demands, as well as research on implementing telemedicine applications in healthcare systems.

Can environmental supervision improve air quality? Quasi-experimental evidence from China

Environmental supervision is significantly disrupted by local economic development and typically characterized by a lack of independence in China. This paper investigates the impacts and mechanisms of the vertical management reform of environmental protection department in China on urban air quality. We construct a principal–agent model suitable for explaining the interactions between the central and local governments and elaborate the intrinsic mechanism of EVM on strengthening environmental supervision. Using manually collected data, we conduct EVM as a quasi-experiment and construct a time-varying difference-in-difference (DID) model. Our empirical results show that the EVM significantly strengthens regional environmental supervision and reduces urban air pollution, bringing abatement in the PM2.5 concentration. The mechanism shows that EVM increases enterprises’ green innovation and attracts new entrants, further promoting industrial upgrading. Our study provides a new perspective on environmental governance and urban air quality in emerging countries such as China.

Principal-Agent Model for Bilateral Contract Design to Incentivize Residential Demand-Side Flexibility

Principal-Agent Model for Bilateral Contract Design to Incentivize Residential Demand-Side Flexibility

Optimal dynamic contract with Knightian uncertainty of ESG rating

In the context of “dual carbon” objectives, ESG investment concept has received wide attention. In this paper, based on stochastic systems and stakeholder theory, we analyze the interest requirements of subject stakeholders and investigate the agency conflict and coordination problems in the system. Combining with the contract theory, we construct a continuous-time principal-agent model with ambiguity aversion under ESG rating Knightian uncertainty. By the method of stochastic calculus in multiple priors, we derive the HJB equation for the optimal dynamic contract value function based on ESG rating Knightian uncertainty under incentive compatibility conditions. Then, for different ESG rating levels, through numerical simulation, we discuss the impact of the Knightian uncertainty degree of ESG rating on the optimal contract. The study shows that as the Knightian uncertainty degree of ESG rating increases, companies are more inclined to green development and the maximum expected return of principals decreases.

Emission-reduction contract with cost information asymmetry for emission reduction service providers: Loose or tight

The asymmetry in emission reduction cost information introduces challenges to the supply chain of emission reduction outsourcing. To address this challenge, we construct principal–agent models of a manufacturer and an emission reduction service provider (ERSP), analyze loose two-part tariff and tight equity contracts, and investigate the contract design and decision distortion change of the manufacturer with information disadvantage when the ERSP faces the moral hazard of hiding emission reduction cost information. Results suggest that the manufacturer should adopt a tight equity contract to obtain higher profits in the presence of symmetric information, especially when the proportion of shareholding is high. However, when the shareholding ratio is low, the manufacturer should adopt a loose two-part tariff contract. Low-cost ERSP has more advantages than high-cost ERSP in concluding transactions. Before a deal is reached, the high-cost ERSP is motivated to hide emission reduction cost information to cooperate with the manufacturer. However, after a deal is reached, the low-cost ERSP is motivated to hide emission reduction cost information to gain higher emission reduction benefits. As a result, manufacturers are placed at an information disadvantage, which leads to the decision distortion of the two contracts. In other words, when cooperating with low- or high-cost ERSP and when the proportion of low-cost ERSP is relatively low, the emission reduction price and level are distorted upward. However, when cooperating the high-cost ERSP and when the proportion of low-cost ERSP is relatively high, the emission reduction price and level are distorted downward, and the tight equity contracts emerge as the dominant strategy.

How does central-local interaction affect local environmental governance? Insights from the transformation of central environmental protection inspection in China

In recent years, one of the most important and innovative policy initiatives introduced by the Chinese government in the field of environmental protection and ecological civilization construction is the Central Environmental Protection Inspection (CEPI). CEPI is seen as a vital tool to encourage local implementation of environmental protection responsibility. Over the course of its operation (eight years), CEPI has transformed from the “campaign” phase to the “convention” phase. It is noted that while provincial governments face a common high-pressure environment created by CEPI, governance scenarios, behaviors, and performance vary across the country significantly. To better understand local governments' environmental governance behaviors under the transformation of CEPI, an integrated analysis framework consisting of two key elements, “central dominance” and “local proactiveness”, is constructed based on the central-local interactions under the principal-agent model. Based on this framework, we conducted a multi-case comparative analysis of four classic cases, with the following findings. (1) Along with the operation of CEPI and its transformation, the interaction between the central and local governments leads to four governance scenarios: “control-active cooperation”, “control-passive cooperation”, “guidance-active promotion”, and “guidance-passive promotion”. (2) Influenced by various factors such as pressure by the central government, local governments' capabilities and governance motivations, local governments form governance behaviors with varying degrees of proactiveness and autonomy. (3) After examining the governance performance of varying behaviors, it is found that local government's “active promotion” behavior can achieve higher governance effectiveness in the “convention” phase. Therefore, it is of policy implication that local governments should be guided to transit from “passive cooperation” to “active promotion”. This paper has important guiding significance for understanding local environmental governance behaviors under strong top-down institutional pressure.

Principal-agent Relationship and Agency Problem

Progressively stricter requirements of labor division have led to the blossom of the principal-agent model, where differences in objective functions between the principal and the agent, as well as information asymmetry, often hinder the principal from maximizing their utility and can result in potential harm to both parties and social welfare. This paper aims to analyze the endogenous causes and issues resulting from the principal-agent model and proposes solutions. Additionally, the shareholder-CEO relationship in finance is applied as a specific case of the principal-agent model for further analysis. Through the construct of a simple model and a signaling mechanism pondering more realistic elements, the negative effect of information asymmetry can be weakened. Lastly, based on the findings of this paper and existing empirical research, the article proposes specific schemes for the above-mentioned mechanism and discusses their implementation and implications. The investigation of principal-agent issues and the proposal of appropriate countermeasures are of great significance and are always frontier concerns for both academia and society.

Incentive pay sensitivity to firm performance prior to anticipated CEO turnover

This study explores whether the sensitivity of CEO compensation to changes in firm performance depends on the CEO's likelihood of leaving the position. In a sample of 3180 US publicly-traded firms, we find that the sensitivity of bonus pay to firm performance is enhanced for a CEO who has reached retirement age. Further, we find that the sensitivity of bonus pay to firm performance is greater when there is evidence of a planned CEO turnover within a two-year window. We show that these findings are consistent with a principal-agent model in which firms who anticipate a greater likelihood of CEO departure find it advantageous to enhance the link between bonus pay and concurrent performance measures to compensate for the lowering of incentives that rely on the manager being employed long-term. The results provide a rationale for including bonus pay in the overall executive compensation package.

Too Much Information: When Does Additional Testing Benefit Schools?

U.S. K–12 school districts that traditionally utilized ongoing “formative” assessments of student progress increasingly rely on additional “interim” assessments to predict student performance on standardized tests. Moreover, some districts are experimenting with merit-based teacher bonuses tied to standardized test scores. We examine the relationship between interim assessments and teacher bonuses using a two-period principal–agent model. The school district (principal), operating under a limited budget, decides whether to implement interim assessments and how much merit pay to offer, and teachers (agents) choose how much effort to exert in each period. We use two-state (proficient versus not proficient) Markovian dynamics to describe the evolution of student test readiness, in which the transition probability in a given period depends on both teachers’ effort decisions and the starting state. Our results indicate that, despite the popularity of interim assessments, their usefulness is far from guaranteed. In particular, the accuracy promised by these assessments is a double-edged sword: positive midyear results can make it easier to incentivize second period teacher effort, but negative results can have a demotivating effect. Moreover, even when an interim assessment does result in a higher probability of the school ending the year in the proficient state, the resulting higher expected costs of merit-based bonuses for the district may exceed the available budget. Thus, even a free interim assessment might be too expensive for the school district. This paper was accepted by Charles Corbett, operations management. Funding: This research was supported by the Risk Management Center Russell Ackoff Doctoral Student Fellowship and the Fishman-Davidson Center for Service and Operations Management, both at The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2020.01547 .

Endogenous criteria for success

Economic agents are motivated to undertake costly actions by the prospect of being rewarded for successes and punished for failures. But what determines what a success looks like? This paper endogenizes the criteria for success in an otherwise standard principal-agent model with risk neutrality and limited liability. The set of feasible contracts is constrained by incentive constraints and possibly by a budget constraint. The first-order approach is not required to solve the problem. If the principal manipulates the criteria for success only to lower implementation costs, and depending on which type of constraint is more restrictive, the second-best action may be above or below the first-best action. In a class of problems where the principal's payoff depends directly on the criteria for success, the second-best solution features either more stringent criteria for success or a lower action (or both) than the first-best solution.

Hot town, corruption in the city: Assessing the impact of form of government on corruption using propensity scores

AbstractThis research explores the relationship between form of government and corruption using national municipal level data (1990–2020) using competing theoretical models; the principal–agent model and the professionalism–performance model. The principal–agent model suggests that the additional scrutiny provided by the electoral process will lead to a lower risk of corruption under the mayor–council form of government. The professionalism–performance model suggests that the professional training and incentives in place in the council–manager form will lead to a lower risk of corruption. However, it is difficult to examine the impact of the form of government on the incidence of corruption because there may be underlying community characteristics, such as population and poverty levels, that drive both the selection of form and corruption. Using propensity score matching and other propensity score methods to reduce the impact of confounding factors, this analysis finds robust evidence that the council–manager form reduces the risk of corruption, supporting the professionalism–performance model.

Technology licensing contract design considering royalty transparency and demand information asymmetry with downstream co-opetition

This paper studies how technology suppliers can optimally design licensing contracts when there is incomplete information on the licensee’s demand potential for the product in a high-technology supply chain. A licensing contract typically contains an up-front payment and royalties on product sales. The licensor decides to license one technology to a licensee, which designs products based on the supplier’s technology and outsources the product manufacturing to a competitive downstream manufacturer. We apply principal-agent models to formulate the licensor’s contracting problem while considering the transparency of the licensing royalty and find that under demand information asymmetry, the optimal contract structure changes with the demand potential. More specifically, both the separating and pooling strategies can be the optimal strategies for the licensor under the observable contract case. Conversely, under the unobservable case, only the separating strategy is the optimal licensing strategy. And the licensor can always charge zero royalty to a high-type design firm regardless of the menu strategy or the single contract. Furthermore, we examine the effect of licensing royalty transparency on licensing decisions and firms’ profits and highlight the effect of downstream competition on the licensor’s profit. Our results show that the licensor can be better off in the observable contract case. By contrast, the design firm may be better off in the unobservable contract case. We provide a rationale for the licensing contract design under demand information asymmetry and further shed light on the choice between public and secret licensing terms.

The bright and dark sides of minority shareholder protection: Evidence from the separate vote counts disclosure rule in China

The separate vote counts (SVC) disclosure rule implemented in 2013 requires Chinese public firms to separately disclose the vote counts of minority shareholders for each proposal. Evaluating the policy's effectiveness in serving its goal of minority shareholder protection, we first find that SVC disclosure enhances minority shareholders' value by suppressing tunneling behaviors and increasing dividend payouts, leading to higher corporate valuation and stock returns. On the other hand, consistent with a principal-agent model that features the information disadvantage of minority shareholders, we find that SVC disclosure leads to lower investment efficiency among firms with higher information asymmetry. Additional tests highlight that counterbalances between majority shareholders, chairperson-CEO separation, and institutional ownership could act as internal and external governing measures that alleviate unintended consequences with respect to investment efficiency.

Optimizing the distribution of outcomes across multiple levels of subcontracting in construction projects

PurposeAlthough outcome sharing in construction is a well-established concept in the literature, there is still an ongoing debate on the most effective approach for distributing project outcomes between an owner and downstream contracting parties (DCPs). To address this issue, this paper aims to investigate an optimal framework for distributing project outcomes among various levels of subcontracting in construction projects. The framework includes contractors, subcontractors, sub-subcontractors and other related parties.Design/methodology/approachTo formulate the optimization problem, the principal–agent model is utilized. The theoretical development is validated through an experiment conducted with employees from road construction companies.FindingsWhen distributing outcomes among various levels of subcontracting, the sharing should be determined by their contribution to the outcome, effort costs, level of outcome uncertainty and risk preference.Originality/valueThis paper expands on the existing principal–agent theory by incorporating multiple levels of agents, transforming the conventional view of outcome sharing among downstream subcontracting levels into testable hypotheses and well-defined concepts. The paper has practical implications for industry practitioners seeking to effectively allocate benefits and costs throughout a project's subcontracting chain.

Learning approximately optimal contracts

In principal-agent models, a principal offers a contract to an agent to preform a certain task. The agent exerts a level of effort that maximizes her utility. The principal is oblivious to the agent's chosen level of effort, and conditions her wage only on possible outcomes. In this work, we consider a model in which the principal is unaware of the agent's utility and action space: she sequentially offers contracts to identical agents, and observes the resulting outcomes. We present an algorithm for learning the optimal contract under mild assumptions. We bound the number of samples needed for the principal obtain a contract that is within ϵ of her optimal net profit for every ϵ>0. Our results are robust even when considering risk averse agents. Furthermore, we show that when there only two possible outcomes, or the agent is risk neutral, the algorithm's outcome approximates the optimal contract described in the classical theory.

Exploration of the long-term performance-oriented incentive mechanism for balancing environmental and economic policies

In the implementation process of economic and environmental policy, a key concerned problem is the inability of some local officials to faithfully implement environmental policies made by the central government in China, as well as many other developing countries. In this paper, a multitask principal-agent model is established to make a comprehensive comparison on the role that the current incentive mechanism (CIM) and the long-term performance-oriented incentive mechanism (LTPOIM) play in policy implementation. In addition, both the incentive effect and the choice of incentive intensity in the LTPOIM are investigated. The results provide the insight that local officials may trade off the efforts of environment protection for economic growth in the CIM. However, local officials are incentivized to allocate higher efforts toward the implementation of environmental policies (IENP) to strengthen environment protection, or invest higher efforts toward IENP and the implementation of economic policies (IECP) to pursue the win-win situation for economy and environment in the LTPOIM. Besides, the chance of distributing higher efforts toward IENP and IECP in the case of complement tasks is higher than that in the case of substitute tasks. The optimal incentive intensities of long-term performance in the case of complement tasks are higher than those in the case of substitute tasks.

Educational Accountability Policy for Sustainable Development: A Comparative Analysis across 30 Countries

This study aims to conduct a comparative analysis regarding Educational Accountability Policies (EAPs) across countries and empirically investigate the factors contributing to the variations in EAP implementation. To achieve these goals, firstly, this study investigated the status of EAP implementation by countries and endeavored to identify the trends regarding the diffusion and variation of EAP. Secondly, this study empirically analyzed the factors associated with variations in EAP implementation across countries. By employing country-level panel data from 30 countries, this study ascertained the status of EAP implementation as a global phenomenon. It examined the factors related to the adoption and intensity of EAP implementation based on the theoretical framework of the principal-agent model. This study has yielded two principal revelations. Firstly, there has been a rapid increase in the number of countries implementing EAP since the 2000s, accompanied by a bolstering of EAP implementation intensity. Nonetheless, there are discernible disparities in the adoption and implementation of EAP by countries. Secondly, this study has revealed that countries characterized by a more advanced economic status or an augmented governmental power tend to exhibit a proclivity for the adoption of EAP. Moreover, countries with a more advanced economic status, an augmented governmental power, or a higher degree of global openness are predisposed to implement EAP with greater intensity. These findings provide significant policy implications for sustainable development in education.

Operational Risk Management: Optimal Inspection Policy

Major banks around the world lost nearly $210 billion during the period of 2011–2016 due to operational risk events. To mitigate the severe consequences that can arise from such events, the Basel Regulatory Committee has mandated that financial institutions worldwide conduct inspections on operational risk. In light of the importance of operational risk and its current regulation in the industry, this paper proposes a continuous-time principal-agent model that explores the optimal inspection policy of a financial firm (principal) and the effort of its employees (agent) to reduce the occurrence of risk events. First, we characterize the optimal inspection strategy under two commonly used policies in practice, namely random and periodic policies. This characterization reveals the conditions for two different modes of inspection (effort inducement and error correction), as well as the nuanced interactions among the inspection frequency, the penalty charged for errors, and the wage paid to employees. Next, by comparing random and periodic policies, we find that the random policy outperforms the periodic policy if and only if the inspection cost is high. Furthermore, we propose a hybrid policy that strictly dominates the random policy and weakly dominates the periodic policy, suggesting that a proper reduction of the random element in the inspection policy, in the manner of our proposed hybrid policy, can always improve its performance. Finally, we examine the complete information benchmark (without moral hazard), supplemental mitigation strategies, and numerical studies to provide further insights and show the robustness of our main findings. This paper was accepted by Vishal Gaur, operations management. Supplemental Material: The e-companion is available at https://doi.org/10.1287/mnsc.2021.00322 .