Bounded Rationality and Private

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Bounded Rationality and Private Information
Chapter 5
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The Motivation Problem
The challenge of arranging an organization so
that selfish individual actions take account of
not only how the decision maker is affected by a
decision but how other are affected as well.
In other words how to organize affairs so
that Individual and organizational goals are
aligned
Incentives
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Complete Contracts
A complete contract requires that all parties
Foresee all possible and relevant contingencies
Agree upon a course of action, including compensat
ion, for each contingency
Willingly abide by all the terms of the contract
no renegotiation
each party must be able to determine if the terms
of the contract are being met
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Problems with Complete Contracts
Bounded Rationality
Opportunistic Behavior
Imperfect Commitment
inefficiencies
Private Information
Adverse Selection
Moral Hazard
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Bounded Rationality and Incomplete Contracts
The concept of bounded rationality explicitly
recognizes the inability of individuals to
foresee all possible contingencies. Instead
individuals may be argued to argued behave
intentionally rational, recognizing informational
limitations.
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Sources of incomplete contracts are
Unforeseen circumstances
Costly calculations
Imprecision of language
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Contractual Responses to Bounded Rationality
Spot market contracts inflexible contracts
with blanket provisions that apply broadly
Relational contracts contracts that state
shared goals and objectives, provision for
dealing with unforeseen circumstances,
specification of power relationships

• Implicit contracts unarticulated and implicit
• understandings about relationships

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Effects of Contractual Incompleteness
Incomplete contracts can lead to imperfect
alignment of motivation schemes and incentives
Commitment
Reneging
Ex Post Renegotiation
Investment and Specific Assets
Specificity defined
Investment and assets defined
Human capital
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Achieving Commitment
Factors which can affect the degree of commitment
to a contract
Reputation
Frequency of transaction/interaction
Structure of the relationship
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Private Information and Precontractual Opportunism
Informational asymmetries and strategic
misrepresentation Efficient trade may not be
possible Achieving efficiency despite
informational asymmetries
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Adverse Selection
Adverse selection is a problem of precontractual
opportunism that arises from the existence of
private information
Is incompatible with the neoclassical account of
markets
Closing of markets
Insurance and markets
Akerlofs market for lemons
Adverse selection and rationing
Credit rationing
Freakonomics after school care
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Signaling, Screening and Self-Selection
Signaling occurs when privately informed parties
take the lead in adopting behavior the reveals
private information when properly interpreted
Skills and education
Home Depot and Lowes Best Buy and Circuit City
Signaling and self-selection
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Signaling, Screening and Self-Selection
(continued)
Screening refers to activities undertaken by the
party without private information in order to
separate informed parties along some dimension
Screening and Age/Wage profiles Performance Pay
and Screening Menus of contracts
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The Bottom Line
Bounded Rationality and precontractual private
information lead to incomplete contracts. They
create significant costs for market-like arms
length transactions
These informational constraints create
inefficiencies in a number of ways
Addressing these inefficiencies is ultimately a
matter of managed coordination and choice of
governance structure