Contract Theory

Course content

The course provides an introduction to contract theory. Contract theory examines the characteristics of optimal contracts when one party has certain relevant knowledge that the other party does not have.

The course consists of two parts. In the first part, some of the basic ideas in contract theory are presented. We will, in particular, look at optimal contracts when one party has hidden information (adverse selection) or can take a hidden action (moral hazard). In the second part of the course we apply the insights obtained to a number of specific economic questions, studying some original journal articles.

In the first part we will study selected sections of chapters 2-5 of the textbook by Laffont and Martimort. Chapter 2 explains the basic idea and insights of adverse selection. Chapter 3 studies some important extensions of the basic adverse selection model: for example, environments where the agent may be of more than two “types”, which may lead to “bunching” (i.e., several types being offered the same contract).

Chapter 4 explains the basic idea and insights of moral hazard, using a very stylized model with two effort levels and two possible outcomes. Chapter 5 extends this model in some interesting ways, for example: environments with a continuous effort variable, leading to a discussion of the so-called first-order approach.

The journal articles that we will study concern various topics, including managerial incentives and product market competition; regulation; and incentives for marketing agents to “missell”.

Education

MSc programme in Economics – elective course

MSc programme in mathematics-economics

 

Learning outcome

The primary aim of the course is to introduce students to central results and insights in contract theory. An additional aim is to familiarize students with some selected examples of how contract theory can be used to study economic questions. A broader aim is that students who take the course will, by working extensively with theoretical models, acquire analytical skills that are transferable to other kinds of intellectual problems.

After having successfully completed the course, the students will be able to formulate and solve contract theory models. The students will also be able to read professional journal articles that apply contract theory and to use this broad analytical approach when analyzing and thinking about questions where incentives play a role.

In order to pass the course, the student must demonstrate familiarity with and understanding of the approach of contract theory. Moreover, the student must show ability to solve and work with models used in contract theory and ability to understand the logic behind the results. At the end of the course, the very good should be able to demonstrate full or almost full capability of using and understanding the techniques of analysis taught in the course.

To sum up, after having completed the course the students should:

Knowledge:

  • Understand the main ideas and results in the contract theory literature.
  • Be familiar with some important analytical techniques used in contract theory.

 

Skills:

  • Be able to formulate and solve contract theory models.
  • Be able to read professional journal articles that apply contract theory.

 

Competencies:

  • Be able to use the broad analytical approach of contract theory when analyzing and thinking about questions and intellectual problems where incentives play a role.

Note: Details of the syllabus may change.

Textbook (selected parts)

Laffont, Jean-Jacques, and David Martimort (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.

Preliminary plan:

  • Sections 2.1-2.6, 2.9, and 2.10 (except 2.10.2 and 2.10.3).

  • Sections 3.1, 3.3.1 (including introduction to 3.3) and 3.7.

  • Introduction to Ch. 4 (pages 145-148), Sections 4.1-4.4 up until and including Proposition 4.5 on page 161.

  • Sections 4.8.2 (on sharecropping) and 4.8.5 (on insurance contracts).

  • Section 4.5 (pages 163-167) – however, the formal model with a risk-averse agent is excluded although the discussion on page 167 is included.

  • Section 5.1.2. Also the discussion related to the first-order approach in Sections 5.1.1 and 5.1.3 (hence not the formal models).

  • Sections 5.2.1 and 5.2.2.

 

Preliminary list of journal articles/book chapters (typically only selected pages):

  • Prendergast, Canice. “The Provision of Incentives in Firms”. Journal of Economic Literature, 37(1), 1999.

  • Vickers, John. “Concepts of competition” Oxford Economic Papers, 47(1), 1995.

  • Inderst, Roman, and Marco Ottaviani. “Misselling through Agents” American Economic Review, 99(3), 2009.

  • Laffont, Jean-Jacques, and Jean Tirole, A Theory of Incentives in Procurement and Regulation, MIT Press, 1993 (parts of Chapter 1).

  • Schmidt, Klaus M. “Managerial Incentives and Product Market Competition”. Review of Economic Studies, 64(2), 1997.

It is recommended that, prior taking the course Contract Theory, the student achieves a certain proficiency in solving game-theoretic models, at the level of Micro III at the Department of Economics. It is also possible to follow Micro III in parallel with the contract theory course. A large part of the course consists of analyzing formal microeconomic models. The students therefore should have a sound knowledge of basic microeconomics and the basic mathematical tools that microeconomists use (e.g., Kuhn-Tucker and similar optimization techniques).

Schedule:
3 hours lectures every week from week 36 to 50 (except week 42).

The overall schema for the Master can be seen at https:/​/​intranet.ku.dk/​economics_ma/​courses/​CourseCatalogue-E17/​Courseschema/​Pages/​default.aspx

Timetable and venue:
To see the time and location of lectures please press the link under "Se skema" (See schedule) at the right side of this page. E means Autumn.

You can find the similar information partly in English at
https:/​​/​​skema.ku.dk/​​ku1718/​​uk/​​module.htm
-Select Department: “2200-Økonomisk Institut” (and wait for respond)
-Select Module:: “2200-E17; [Name of course]””
-Select Report Type: “List – Weekdays”
-Select Period: “Efterår/Autumn – Weeks 31-5”
Press: “ View Timetable”

ECTS
7,5 ECTS
Type of assessment
Written examination, 3 hours under invigilation
Individual exam at the computers of Copenhagen University.
The exam assignment is given in English and can be answered in English or in Danish. Language must be chosen at the course or exam registration.
Aid
Without aids
Marking scale
7-point grading scale
Censorship form
External censorship
if chosen by the Head of Studies.
Criteria for exam assessment

The student must in a satisfactory way demonstrate that he/she has mastered the learning outcome of the course.

The final exam tests the students' knowledge, skills, and competencies in corporate finance theory, as described in the course learning outcomes.  Grading is on a pass/fail basis. In order to obtain a passing grade, students must demonstrate in a satisfactory way that they have met the learning outcomes related to all three relevant areas: intuition, formal mathematical modeling, and application to cases.

Single subject courses (day)

  • Category
  • Hours
  • Lectures
  • 42
  • Preparation
  • 161
  • Exam
  • 3
  • English
  • 206