The Theory of Incentives

"Incentive theory is at the very core of economics. This text is a masterly exposition of the modern theory by one of the pioneers of the field, Jean-Jacques Laffont, together with one of its rising stars, David Martimort." - Eric Maskin, Institute for Advanced Study "This book will surely be the standard technical reference in an important field for a number of years - possibly for many if the field ceases to develop so rapidly. It is indeed a fine contribution to the economics literature." - Sir James Mirrlees, Cambridge University, 1996 Nobel Laureate in Economic Sciences "The most important development in economics in the last forty years has been the study of incentives to achieve potential mutual gains when the parties have different degrees of knowledge. The time is ripe for a synthesis and systematization. Jean-Jacques Laffont has been one of the most important contributors to the field over the years, and David Martimort has shown his capacity for highly original work. This book combines clarity, thoroughness, and great respect for historical development." - Kenneth J. Arrow, Stanford University, 1972 Nobel Laureate in Economic Sciences

Jean-Jacques Laffont is Professor of Economics and Director of the Institut d'Economie Industrielle (IDEI) at the University of Social Sciences in Toulouse, one of Europe's leading centers for the study of economics. He has won a number of prestigious awards for his research and is a former President of the European Economic Association and of the Econometric Society. His books include The Economics of Uncertainty and Information, Fundamentals of Public Economics, Incentives and Political Economy, and he is the coauthor of Incentives in Public Decision Making. A Theory of Incentives in Procurement and Regulation, and Competition in Telecommunications. David Martimort is Professor of Economics and a research fellow of the IDEI at the University of Social Sciences in Toulouse. He has been a visiting professor at Harvard, MIT, Pompeu Fabra in Barcelona, ECARE in Brussels, and is a member of the Center for Economic and Policy Research in the United Kingdom. He is Associate Editor of the Rand Journal of Economics.

xi Foreword Introduction 1 1 Incentives in Economic Thought 7 1.1 Adam Smith and Incentive Contracts in Agriculture 8 1.2 Chester Barnard and Incentives in Management 11 1.3 Hume, Wicksell, Groves: The Free-Rider Problem 14 1.4 Borda, Bowen, Vickrey: Incentives in Voting 15 1.5 Leon Walras and the Regulation of Natural Monopolies 18 1.6 Knight, Arrow, Pauly: Incentives in Insurance 18 1.7 Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives 20 1.8 Dupuit, Edgeworth, Pigou: Price Discrimination 22 1.9 Incentives in Planned Economies 23 1.10 Leonid Hurwicz and Mechanism Design 25 1.11 Auctions 27 2 The Rent Extraction-Efficiency Trade-Off 28 2.1 The Basic Model 32 2.2 The Complete Information Optimal Contract 33 2.3 Incentive Feasible Menu of Contracts 36 2.4 Information Rents 39 2.5 The Optimization Program of the Principal 40 2.6 The Rent Extraction-Efficiency Trade-Off 41 2.7 The Theory of the Firm Under Asymmetric Information 46 2.8 Asymmetric Information and Marginal Cost Pricing 48 2.9 The Revelation Principle 48 2.10 A More General Utility Function for the Agent 51 2.11 Ex Ante versus Ex Post Participation Constraints 57 2.12 Commitment 63 2.13 Stochastic Mechanisms 65 2.14 Informative Signals to Improve Contracting 68 2.15 Contract Theory at Work 72 Appendix 81 3 Incentive and Participation Constraints with Adverse Selection 82 3.1 More than Two Types 86 3.2 Multidimensional Asymmetric Information 93 3.3 Type-Dependent Participation Constraint and Countervailing Incentives 101 3.4 Random Participation Constraint 115 3.5 Limited Liability 118 3.6 Audit Mechanisms and Costly State Verification 121 3.7 Redistributive Concerns and the Efficiency-Equity Trade-Off 134 Appendices 130 4 Moral Hazard: The Basic Trade-Offs 145 4.1 The Model 148 4.2 Risk Neutrality and First-Best Implementation 153 4.3 The Trade-Off Between Limited Liability Rent Extraction and Efficiency 155 4.4 The Trade-Off Between Insurance and Efficiency 158 4.5 More than Two Levels of Performance 163 4.6 Informative Signals to Improve Contracting 167 4.7 Moral Hazard and the Theory of the Firm 172 4.8 Contract Theory at Work 174 4.9 Commitment Under Moral Hazard 184 Appendices 185 5 Incentive and Participation Constraints with Moral Hazard 187 5.1 More than Two Levels of Effort 191 5.2 The Multitask Incentive Problem 203 5.3 Nonseparability of the Utility Function 226 5.4 Redistribution and Moral Hazard 232 Appendices 235 6 Nonverifiability 260 6.1 No Contract at Date 0 and Ex Post Bargaining 242 6.2 Incentive Compatible Contract 244 6.3 Nash Implementation 246 6.4 Subgame-Perfect Implementation 256 6.5 Risk Aversion 261 6.6 Concluding Remarks 264 7 Mixed Models 265 7.1 Adverse Selection Followed by Moral Hazard 269 7.2 Moral Hazard Followed by Adverse Selection 294 7.3 Moral Hazard Followed by Nonverifiability 298 8 Dynamics Under Full Commitment 303 8.1 Repeated Adverse Selection 307 8.2 Repeated Moral Hazard 319 8.3 Constraints on Transfers: The Role of Implicit Incentives 342 9 Limits and Extensions 347 9.1 Informed Principal 351 9.2 Limits to Enforcement 360 9.3 Dynamics and Limited Commitment 364 9.4 The Hold-Up Problem 370 9.5 Limits to the Complexity of Contracts 375 9.6 Limits in the Action Space 387 9.7 Limits to Rational Behavior 391 9.8 Endogenous Information Structures 395 References 399 Author Index 413 Subject Index 417