Somehow, we need to find a some common ground between these opposite objectives.

Let’s plot the relationship between effort and utility.

By convention we assume that all utility functions are expressed in monetary terms.

For the principal, as you can see, the utility function is monotonically increasing in effort.

For the agent, the function is monotonically decreasing.

Assume that we are considering a lump sum compensation.

The principal pays a given amount of money to the agent for his/her effort.

The question is: “What is the optimal compensation?”

Now, let’s plot the agent’s effort disutility of effort as a cost function.

The cost of effort is the opposite of utility.

That is, it is obtained multiplying the money-metric utility function by -1.

Let’s combine the two graphs.

The principal would like to design a contract, so that his/her profits are maximized.

Because of the Individual rationality constraint, the agent must receive compensation that is

at least equal to the cost of effort.

For simplicity, we assume that the opportunity cost of signing the contract is zero.

Therefore, the agent’s utility, if the contract is not signed, is equal to zero.

Thus, the red curve is the minimum compensation that the principal must pay to the agent

for the given level of effort.

The green curve is the principal’s gain from the contract before paying the agent’s compensation.

We assume that the principal’s reservation utility is zero.

We want to find the point that maximizes the distance between the two curves.

In this way, the coordination surplus is maximized.

Standard microeconomic theory tells us that the maximizing effort is found at the intersection

of the principal’s marginal utility curve and the agent’s marginal cost curve,

in a graph like this one.

At the intersection we find the optimal effort level and the value of the corresponding compensation.

The resulting design of the contract is this: the principal asks the agent for the optimal effort level

and in return he/she pays the agent a hourly wage that is equal to the marginal cost of effort.

The question is: “Is this contract self-enforcing?”.

Without perfect monitoring and enforcement, the agent can maximize his/her own profits

by taking the money, while not providing any effort.

For example, he/she can take the money, and then sleep for the whole time.

In this case, the wage is high, but the actual effort is zero.

Therefore, the principal’s utility is equal to zero as well.

As you can see, opportunism can be a serious problem.

In the next lesson, we will go through a simple example

to discuss the possible solutions to this problem.

Well, this is all for now.

Thank you for watching this video.