CONTRACTING WITH IMPERFECT INFORMATION

Contracting with Imperfect Information

Usually, contracts that are well designed can resolve issues such as incentive problems at a low cost. However, contracts often fail in accomplishing this objective. Also, contracts in practice tend to be costly for negotiation, writing, administration, and enforcement. One of the factors that significantly limits the ability of a contract to resolve any incentive conflict is costly information. Information is asymmetric, where the seller or the buyer knows more about the profits than the other party, taking advantage of the other party. For instance, the seller may be more aware of the potential profit and the consumers perk consumption (Brickley, Smith & Zimmerman, 2015). Given such a distribution of information, controlling the customers consumption perk takes a compensation contract. This needs perfect information regarding the firms potential profit becomes infeasible.

The general information problems arising in contracting are information asymmetries that result before the negotiation of the contract and information asymmetries that occur during the implementation process of the contract. Information problems that take place after the contract negotiation that might arise include agency problems. An agency relationship is one in which one party, usually the principal, engages the second party, in this case, the agent, to perform various tasks on the principals behalf. For example, shareholders within a corporation can appoint a board of directors to help them oversee the corporations management. Much of the operating authority is delegated to the senior executives by the board, who then assign the necessary tasks to the employees in the lower levels within the corporation.

Usually, the incentives of the agents and the principal fail to be automatically aligned, which results in agency problems. This means that agents have the incentive to partake in actions to increase their well-being at the principals expense after the contract is set. Typically, asymmetric or imperfect information precludes the costless resolution of such contracting problems. The principal cannot necessarily observe every action of the agent costless. This gives the agent the chance to take perk consumption without the same actions invariably being detected by the principal (Brickley, Smith & Zimmerman, 2015).

Nonetheless, the principal can limit such behavior by establishing appropriate incentives for the agent by incurring monitoring and contract costs. Agents can also incur bonding costs that guarantee that they dont take any action at the principals expense or by ensuring that the principal is duly compensated should they do so. The agent, therefore, shows their willingness to pay to incur such expenses to increase the amount paid by the principal to the agent for the agents services. If controlling such contracting problems is costly, it generally doesnt pay for either of the parties involved to incur sufficient costs to guarantee that the agent completely follows the principals wishes.

At some points, the marginal cost (MC) exceeds the marginal benefits (MB) of any additional expenditure to increase compliance (Brickley, Smith & Zimmerman, 2015). To illustrate the concept of agency cost and information asymmetry, a manufacturing firm is taken into consideration....

The manufacturing firm is unwilling to pay as much for the anticipated fewer hours as if it got 100 hours of legal services. The second graph illustrates this outcome. The triangle represents the residual loss which is the lost surplus resulting from the inefficiency to solve the incentive problem completely. Additionally, the two firms each cater for the monitoring and bonding costs which further reduce the surplus as shown by rectangle 0. Therefore, the remaining surplus will equal the original surplus minus the total contracting cost (the total out-of-pocket costs and the residual costs). In the end, both firms will have made net benefits placing them in a far much better position than when there are no incentive problems or information asymmetry (Brickley, Smith & Zimmerman, 2015).

Conclusion

If the planning, negotiation, writing, and enforcement of contracts were a costless plan, it would be even easier to purchase them from an outside supplier since it would not necessarily matter. However, contracting can be very costly, especially because it is difficult to oversee and plan for every possible contingency. Also, contracts can be costly because they can be very expensive to negotiate and enforce. Contracting costs, therefore, necessitate incomplete contracts in which several contingencies are eliminated to leave room for future negotiation. When contractual issues or problems arise, the parties involved might incur legal expenses or other losses. Prospective future negotiations can encourage suboptimal investment. The parties involved in a contract must realize and accept that partial gains from their investments…