Informational Asymmetry in Agency, Bargaining and Market Contexts

Abstract

The standard micro-economic theory, as epitomized by Walras-Arrow -Debreu’s “General equilibrium theory", assumes that all the economic agents have complete information about their environment. But one comes across many real world institutions such as labour, insurance, stock, and auction markets as well as common place interactions such as those between a buyer and a seller, a physician and a patient, a plaintiff and a defendant, which are characterized by varying degrees of informational asymmetries. These asymmetries arise due to the private knowledge available to one or both of the parties. Research into these informational aspects of the economic activity is a major pre-occupation of the present day economic theorists and this broad spectrum comes under the rubric of 'Economics of Information’. This thesis work attempts to address issues related to three of the major constituents of information economics viz., agency theory, bargaining theory and the theory of rational expectations. Each one of these branches, though connected by a common thread, require different modelling tools and differs considerably in detai1. We develop a common framework for studying informational asymmetries using classic examples from the literature in the first chapter. Agency, bargaining and rational expectation theories are linked to the common programme of general equilibrium theory through an appraisal of historical antecedents of information economics. This chapter also presents the objectives and an overview of the thesis. In the standard agency model, a risk neutral principal employs a risk averse agent to put efforts in realizing a goal. The agent’s actions might be unobservable (hidden action) or he may have some private knowledge relevant to the contractual relationship with the principal (hidden knowledge) or both his actions and knowledge might be hidden. In such cases, the principal should devise his optimal incentive contracts based on some imperfect indicators of the agent’s efforts. In the second chapter we present a new framework for the construction of such optimal contracts in static and dynamic contexts. Traditionally the static agency problem has been formulated as a constrained optimization problem and the existence of an optimal contract is shown using Karush-Kuhn-Tucker conditions. IV I What is missing in literature is a constructive method of proof to find the optimal contract. Using nonlinear functional analytic methods, such a method is developed for the infinite dimensional case. Multi-period agency relationships are observed in many economic contexts such as labour market. One needs to analyze the reasons behind the existence as also the nature of such dynamic contracts. Whether such contracts lead to first best optimal solutions and whether they could be replaced by a sequence of short term contracts are some of the prominent questions that arise. We develop a framework using stochastic dynamic programming methods to study the learning possibilities of the principal in the dynamic contexts marked by hidden action, hidden knowledge as well as a combination of the two. For all the three cases we show that the principal could achieve the first-best outcome when there is discounting. In the third chapter, we apply the agency theory results to study the important problem of intergenerational sharing of a fixed exhaustible resource. Given an exhaustible resource whose size of stock is unknown, a major normative problem is to distribute this stock over different generations. This normative problem can be stated as follows: The present generation has inherited an exhaustible resource which is a common good. It has to extract the resource optimally and also invest a large amount of its wealth and effort in R&D to improve this resource usage. Alternatively, it should invest in R&D to find a technological alternative or substitute. Ethically, it may be argued that risk and uncertainty should be shared by the posterity, which is to benefit from such investments. After a succinct review of various ethical rules involved, we formulate this problem as an agency model and characterize the optimal resource sharing mechanism taking- into account the informational asymmetries. From the contractual relationship we move on to bargaining models in the fourth chapter. We consider a two sided incomplete information, non-cooperative bargaining model with infinite time horizon between a buyer and a seller who bargain over the price of an object to be sold. In general, such a model would yield multiple Nash equilibria. We try to circumvent this problem by modelling the above bargaining problem as a non-zero sum Dynkin game wherein the player’s strategies are stopping times. These strategies satisfy the properties of a lattice and hence using the lattice theoretic methods we are able to characterize the multiple : V i i ) Nash equilibrium set. For a special case, we construct the subgame perfect equilibrium strategies. Common knowledge assumption is fundamental to information economics and game theory. This assumption requires the economic agents to have common priors. In the fifth chapter, we consider the case of agents with different priors and develop an alternative notion called 'common perception’. Using this model, we analyze Aumann’s 'agreeing to disagree’ principle which states that the agents whose priors are common cannot agree to disagree. We then verify the existence of the rational expectations equilibrium for the case of agents with different priors. According to this paradigm, agents with lesser information can learn about the private information of the more informed by observing a market aggregate such as price. We show that such learning can take place only under very restrictive conditions. In the sixth chapter, we study a real world legal case between the Government of India and the Union Carbide Corporation, arising out of the Bhopal gas disaster, using the concepts of information economics. Many issues such as the choice of the foreign court, the delay in the settlement, bargaining inefficiency, the nature and form of lawyer’s contracts as well as the choice of the legal standards are analyzed. As an offshoot, we disprove Coase’s conjecture on the efficiency of bilateral bargaining. The relevance of bargaining models in particular and information economics in general, to the economics of law are brought out. Also, these analyses help to illustrate the practical relevance of the theoretical models developed in the earlier chapters. The final chapter presents a retrospective summary of the thesis and points out some specific open problems and issues that could become topics of future research.