Industrial Organization III: Contract Theory
Professor Ingela Alger
Spring 2002 (EC855.01)
Economics Department, Boston College
Carney 244
tel: (617) 552-1589
e-mail: ingela.alger@bc.edu
Office hours: Wednesdays 12.30-3.30
Description
The main objective of this course is to provide you with the theoretical tools that are commonly
used to analyze situations with asymmetric information. Various applications to IO will be
covered throughout the course.
Grading
Course requirements and grading will ultimately depend on the number of students who take the
class (paper presentations will be required if there are few students). However, there will in any
case be two exams, which will account for the main part of the grade (60-80%), and problem sets
(20-30%).
Course Material and Outline
Main References
1. Fudenberg D., J. Tirole. Game Theory. Cambridge: MIT Press, 1991 (FT)
2. Mas-Colell A., Whinston M.D., J.R. Green. Microeconomic Theory. Oxford: Oxford
University Press, 1995 (MWG)
3. Salanie B. The Economics of Contracts. Cambridge: MIT Press, 1997 (S)
Books applying contract theory to specic topics include:
1. Laffont J.-J., Tirole J. A Theory of Incentives in Procurement and Regulation. Cambridge:
MIT Press, 1993 (LT)
2. Tirole J. The Theory of Industrial Organization. Cambridge: MIT Press, 1988 (T)
3. Hart O. Firms, Contracts, and Financial Structure.Oxford: Oxford University Press, 1995 (H)
The following books provide examples that motivate the use of contract theory, and develop
many interesting questions on an intuitive level:
1. Milgrom P., Roberts J.. Economics, Organization & Management, Englewood Clis. NJ:
Prentice Hall, 1992 (MR)
2. Williamson O. The Economic Institutions of Capitalism. New York: The Free Press, 1985.
(W)
Course Outline
* = required reading
I. Introduction
1. *(S) Chapter 4.1
2. *(MWG) Chapter 13.A and 13.B
3. Akerlof G.A. The Market for `Lemons: Quality Uncertainty and the Market Mechanism.
Quarterly Journal of Economics, 84: 488-500, 1970.
4. *(Introduction) Hart O., Holmstrom B. The Theory of Contracts in T. Bewley. ed. Advances
in Economic Theory, 5th World Congress of the Econometric Society. Cambridge:
Cambridge University Press,1987
5. *(Introduction and Section 1.1) Laffont J.-J., E. Maskin. The Theory of Incentives: An
Overview in W. Hildenbrand, ed. Advances in Economic Theory, 4th World Congress of the
Econometric Society. Cambridge: Cambridge University Press,1982
II. Some game theory
1. Chapter 7 of (MWG) is a good (re-)introduction to game theory.
2. The concepts that are used in the course are: Nash Equilibrium, Subgame Perfect
Equilibrium,
3. Bayesian Equilibrium, Perfect Bayesian Equilibrium.
4. These are explained in *(S) Game Theory Appendix.
5. For further comments, see Section 1.2 in Laffont J.-J., E. Maskin, 1982.
6. Other sources you may use include: (T) Chapter 11, (MWG) Chapters 7, 8D, 8E, 9.A-9.C
and (FT) Chapters 1, 3, 6, 8.1-8.2.
III. Hidden information (Adverse Selection)
A. Introduction
1. *(S) Chapter 1
2. *(FT) Introduction to Chapter 7 (Sections 1.3 and 2.1) Laffont J.-J., E. Maskin, 1982.
B. The Basic Model (one principal, one agent, full commitment)
1. *(S) Chapter 2
2. *(FT) Chapter 7.1-7.3
3. (MWG) Chapter 14.C
4. Guesnerie R., Laffont J.-J. A Complete Solution to a Class of Principal - Agent Problems
with an Application to the Control of a Self-Managed Firm. Journal of Public Economics,
25:329-369, 1984.
C. Applications
 Second-Degree Price Discrimination
1. *(S) Chapter 2.2
2. *(T) Chapter 3
3. Maskin E., Riley J. Monopoly with Incomplete Information. RAND Journal of Economics,
15: 71-196, 1984.
4. Mussa M., Rosen S.Monopoly and Product Quality. Journal of Economic Theory, 18:301317, 1978.
5. Alger I. Consumer Strategies Limiting the Monopolist's Power: Multiple and Joint
Purchases. RAND Journal of Economics, 30:736-757, 1999.
6. Stole L.A.Nonlinear Pricing and Oligopoly. Journal of Economics & Management Strategy,
4:529-62, 1995.
 Regulation
1. *(S) Chapter 3.1.1
2. *(LT) Introduction + Chapter 1.1-1.6
3. Baron D.P.,. Myerson R.B. Regulating a Monopolist with Unknown Costs. Econometrica,
50:911-930,1982..
4. Laffont J-.J., Tirole J. Using Cost Observation to Regulate Firms. Journal of Political
Economy, 94:614-641, 1986.
5. Auriol E., Laffont J.-J. Regulation by Duopoly. Journal of Economics & Management
Strategy, 1:507-533, 1992.
6. Survey: Laffont J-.J. The New Economics of Regulation Ten Years After. Econometrica,
62:507-537, 1994.
D. Extensions
 Multiple Agents: Mechanism Design and Bilateral Trading
1. *(FT) Chapters 7.4 and 7.5
2. *(MWG) Chapter 23
3. Groves T. Incentives in Teams. Econometrica, 41:617-631, 1973.
4. Clarke E. Multipart Pricing of Public Goods. Public Choice, 8:19-33, 1971.
5. D'Aspremont C., Gerard-Varet L.-A. Incentives and Incomplete Information. Journal of
Public Economics, 11:25-45, 1979
6. Mookherjee D., Reichelstein S. Dominant Strategy Implementation of Bayesian Incentive
Compatible Allocation Rules. Journal of Economic Theory, 56:378- 99, 1992.
7. Myerson R.B., M. Satterthwaite. Efficient Mechanisms for Bilateral Trading. Journal of
Economic Theory, 28:265-281, 1983.

Application: Auctions
1. *(S) Chapter 3.2.2
2. *(LT) Chapters 7.1-7.3
3. McAfee R.P., McMillan J. Auctions and Bidding. Journal of Economic Literature, 25:699738, 1987
4. Bulow J., Roberts J. The Simple Economics of Optimal Auctions. Journal of Political
Economy, 97:1060-1090, 1989
5. Dasgupta P., Maskin E. Efficient Auctions. Quarterly Journal of Economics, 115:341-388,
2000
6. Survey: Klemperer P. Auction Theory: A Guide to the Literature in Dahiya, Shri Bhagwan,
ed., The Current State of Economic Science, Rohtak, India: Spellbound. 1999
 Multiple Agents: Correlated Types
1. *(FT) Chapter 7.6.1
2. *Cremer J., McLean R.P. Optimal Selling Strategies under Uncertainty for a Discriminating
Monopolist when Demands are Interdependent. Econometrica, 53:345-361, 1985
3. Demski J.S., Sappington D. Optimal Incentive Contracts with Multiple Agents. Journal of
Economic Theory, 33:152-171, 1984.
4. Moore J., Turnbull S. Stopping Agents from `Cheating'. Journal of Economic Theory,
46:355-72, 1988
 Multiple Agents: Collusion
1. Tirole J. Hierarchies and Bureaucracies: On the Role of Collusion in Organizations. Journal
of Law, Economics, and Organizations, 2:181-214, 1986.
2. Survey: Tirole J. Collusion and the Theory of Organizations in J.-J. Lafont, ed., Advances in
Economic Theory: Proceedings of the Sixth World Congress of the Econometric Society.
Cambridge; Cambridge University Press.151-206, 1992
3. Survey: Laffont, J-.J., Rochet J-.C. Collusion in Organizations. Scandinavian Journal of
Economics, 99:485-495,1997
4. Kofman F., Lawarree J. Collusion in Hierarchical Agency. Econometrica, 61:629-56, 1993
5. Laffont J-.J., Martimort D. Collusion under Asymmetric Information. Econometrica,
65:875-911, 1997
6. Laffont J-.J., Martimort D. Collusion and Delegation. RAND Journal of Economics, 29:280305, 1998
7. *Laffont J-.J., Martimort D. Mechanism Design with Collusion and Correlation.
Econometrica, 68:309-42, 2000
8. Faure-Grimaud A., Laffont J.-J., Martimort D. The Endogenous Transaction Costs of
Delegated Auditing. European Economic Review, 43:1039-1048, 1999.
9. Laffont J.-J. Political Economy, Information and Incentives. European Economic Review,
43:649-669, 1999
1.
2.
3.
4.
5.
 No Commitment
*(S) Chapter 6 (except 6.5)
*(LT) Chapters 9 and 10
*Bester, H., R. Strausz. Contracting with Imperfect Commitment and the Revelation
Principle: The Single Agent Case. Econometrica, 69:1077-98, 2001.
Freixas X., Guesnerie R., Tirole J. Planning under Incomplete Information and the Ratchet
Effect. Review of Economic Studies, 52:173-191, 1985.
Dewatripont M. Renegotiation and Information Revelation over Time: The Case of Optimal
Labor Contracts," Quarterly Journal of Economics, 104:589-619, 1989.
 Alternative Participation Constraints
1. *(S) Chapter 3.1.3. and 3.2.3
2. *Jullien, B.Participation Constraints in Adverse Selection Models," Journal of Economic
Theory, 93:1-47, 2000
3. Rochet J.-C., Stole L. Nonlinear Pricing with Random Participation Constraints.
forthcoming Review of Economic Studies, 2000
 Countervailing Incentives
1. *(S) Chapter 3.2.7
2. Lewis T., Sappington D. Countervailing Incentives in Agency Theory. Journal of Economic
Theory, 49:294-313, 1989
 Costly State Veri_cation
1. Townsend R. Optimal Contracts and Competitive Markets with Costly State Verification.
Journal of Economic Theory, 21:265-293, 1979
2. Mookherjee D., Png I. Optimal Auditing, Insurance, and Redistribution. Quarterly Journal of
Economics, 104:399-415, 1989.
3. Bolton P., Scharfstein D.S. A Theory of Predation Based on Agency Problems in Financial
Contracting. American Economic Review, 80:93-106, 1990.
4. Gale D., Hellwig M. Incentive-Compatible Debt Contracts: The One-Period Problem.
Review of Economic Studies, 52:647-663, 1985.
 Endogenous Asymmetric Information; Input v. Output Monitoring
1. Cremer J., Khalil F. Gathering Information Before Signing a Contract. American Economic
Review, 82:567-578, 1992.
2. Khalil F., Lawarree J. Input versus Output Monitoring: Who Is the Residual Claimant?
Journal of Economic Theory, 66:139-157, 1995.
 Multi-Dimensional Private Information
1. *(S) Chapter 3.2.4
2. Survey: Armstrong M., Rochet J-.C. Multi-Dimensional Screening: A User's Guide.
European Economic Review, 43:959-979, 1999.
3. Rochet J.-C., P. Chone . Ironing, Sweeping and Multi-Dimensional Screening.
Econometrica, 66:783-826, 1998.
 Communication Costs and Ethics
1. *Green J.R., Laffont J.-J.Partially Veriable Information and Mechanism Design. Review of
Economic Studies, 53:447-456, 1986.
2. Kofman F., Lawarree J. On the Optimality of Allowing Collusion. Journal of Public
Economics, 61:383-407, 1996.
3. Alger I., Renault R. Screening among Agents with Heterogeneous Ethics. Boston College
WP 489, 2000.
4. Alger I., Renault R. Honest Agents and Equilibrium Lies mimeo. Boston College and
Universite de Cergy-Pontoise, 2000.
5. Alger I., A.C.-t. Ma Moral Hazard, Insurance, and Some Collusion forthcoming Journal of
Economic Behavior and Organization, 1998
6. *Deneckere R, Severinov S. Mechanism Design and Communication Costs.mimeo
University of Wisconsin, 2001
7. Lacker J.M., Weinberg J.A. Optimal Contracts under Costly State Falsification. Journal of
Political Economy, 97:1345-1363, 1989.
8. Maggi G. and A. Rodriguez-Clare. Costly Distortion of Information in Agency Problems.
Rand Journal of Economics, 26:675-689, 1989.
9. Crocker K.J., Morgan J.Is Honesty the Best Policy? Curtailing Insurance Fraud through
Optimal Incentive Contracts. Journal of Political Economy, 106:355-375, 1998
1.
2.
3.
4.
 Informed Principal
*(S) Chapter 3.2.6
*(FT) Chapter 7.6.3
Myerson, R.B. Mechanism Design by an Informed Principal. Econometrica, 51:1767-1797,
1983
Maskin E., Tirole J. The Principal-Agent Relationship with an Informed Principal: The Case
of Private Values. Econometrica, 58:379-409, 1990.
5. Maskin, E., Tirole J. The Principal-Agent Relationship with an Informed Principal, II: The
Case of Common Values. Econometrica, 60:1-42,1992
 12. Multiple Principals
1. *(FT) Chapter 7.6.5
2. Epstein L.G., Peters M. A Revelation Principle for Competing Mechanisms. Journal of
Economic Theory, 88:119-160, 1999.
3. *Martimort, D., Stole L. The Revelation and Delegation Principles in Common Agency
Games. forthcoming Econometrica, 2001
4. Martimort D. The Multiprincipal Nature of Government. European Economic Review,
40:673-85, 1996.
5. Martimort D.Exclusive Dealing, Common Agency, and Multiprincipals Incentive Theory"
RAND Journal of Economics, 27:1-31, 1996.
E. Related Topics: Screening on a Competitive Market, and Signaling
1. *(S) Chapter 3.2.1
2. *(MWG) Chapter 13.D
3. Rothschild M., Stiglitz J. Equilibrium in Competitive Insurance Markets: An Essay on the
Economics of Imperfect Information. Quarterly Journal of Economics, 90:629-649, 1976.
4. Wilson C. A Model of Insurance with Incomplete Information. Journal of Economic Theory,
16:167-207, 1977.
5. Riley J. Informational Equilibrium. Econometrica, 47:331-359, 1979
6. Survey: Hellwig M. Some Recent Developments in the Theory of Competition in Markets
with Adverse Selection. European Economic Review, 31:319-325, 1987
7. *(S) Chapter 4
8. *(MWG) Chapter 13.C
9. Spence M. Job Market Signaling. Quarterly Journal of Economics, 87:355-374, 1973
10. Crawford V., Sobel J. Strategic Information Transmission. Econometrica, 50:1431-1451,
1982
IV. Hidden action (Moral Hazard)
A. Introduction
1. *(S) Chapter 5.1
2. (Section 1) Hart O., Holmstrom B., 1987
B. The Basic Model (one principal, one agent, commitment)
1. *(S) Chapters 5.2 through 5.3.4
2. (MWG) Chapter 14.B
3. Holmstrom B. Moral Hazard and Observability. Bell Journal of Economics,10:74-91, 1979
4. Shavell S. Risk Sharing and Incentives in the Principal and Agent Relationship. Bell Journal
of Economics, 10:55-73, 1979
5. Grossman S.J., Hart O.D. An Analysis of the Principal-Agent Problem. Econometrica, 51:745, 1983.
6. Rogerson W. The First-Order Approach to Principal-Agent Problems. Econometrica,
53:1357-1368, 1985.
C. Extensions
 Multiple Agents
1. *(S) Chapter 5.3.5
2. *Holmstrom B. Moral Hazard in Teams.Bell Journal of Economics, 13:324-340, 1982.
3. Green J.R., Stokey N.L. A Comparison of Tournaments and Contracts. Journal of Political
Economy, 91:349-364, 1983.
4. Mookherjee D. Optimal Incentive Schemes in Multi-Agent Situations. Review of Economic
Studies, 51:433-446, 1984.
5. Holmstrom B., Milgrom P. Regulating Trade Among Agents. Journal of Institutional and
Theoretical Economics, 146:85-105, 1990
6. Itoh H. Incentives to Help in Multi-Agent Situations. Econometrica, 59:611-636, 1991
7. *Itoh H., Ishiguro S. Moral Hazard and Renegotiation with Multiple Agents. Review of
Economic Studies, 68:1-20, 2001
 Multiple Principals
1. Bernheim B.D., Whinston M.D. Common Agency. Econometrica, 54:923-942, 1986
 Multitasking
1. *(S) Chapter 5.3.7
2. Holmstrom B., Milgrom P. Multitask Principal-Agent Analyses: Incentive Contracts, Asset
Ownership and Job Design. Journal of Law, Economics and Organization, 7:24-51, 1991
1.
2.
3.
4.
5.
6.
 Multiple Periods
*(S) Chapter 6.5
Holmstrom B., Milgrom P. Aggregation and Linearity in the Provision of Intertemporal
Incentives. Econometrica, 55:303-328, 1987
Fudenberg D., Tirole J. Moral Hazard and Renegotiation in Agency Contracts.
Econometrica, 58:1279-1320, 1990.
Ma, C.-t.A. Adverse Selection in Dynamic Moral Hazard. Quarterly Journal of Economics,
106:255-75, 1991
Chiappori P.-A., Macho I., Rey P., Salanie B. Repeated Moral Hazard: The Role of
Memory, Commitment and the Access to Credit Markets. European Economic Review,
38:1527-1553, 1994
*Matthews S.A. Renegotiating Moral Hazard Contracts under Limited Liability and
Monotonicity. Journal of Economic Theory, 97:1-29, 2001
 Limited Liability
1. Sappington D. Limited Liability Contracts between Principal and Agent. Journal of
Economic Theory, 29:1-21, 1983
 Models with Moral Hazard and Adverse Selection
Myerson R. Optimal Coordination Mechanisms in Generalized Principal-Agent Problems.
Journals of Mathematical Economics, 10:67-81, 1982.
2. Guesnerie R., Picard P., Rey P.Adverse Selection and Moral Hazard with Risk Neutral
Agents. European Economic Review, 33:807-23, 1989
1
D. Applications
 Work Incentive Scemes
1 *(S) Chapter 5.4.2
2 Shapiro C., Stiglitz J. Equilibrium Unemployment as a Worker Discipline Device. American
Economic Review, 74:433-444, 1984.
3. Baker G., Jensen M., Murphy K. Compensation and Incentives: Practice vs. Theory. Journal
of Finance, 43:593-616, 1988.
4. Jensen M. ,. Murphy K Performance Pay and Top-Management Incentives. Journal of
Political Economy, 98:225-264, 1990
5. Rosen S. Contracts and the Market for Executives in L. Werin and H. Wijkander, eds.,
Contract Economics, Oxford: Basil Blackwell, 1992
1.
2.
3.
4.
 Career Concerns
Holmstrom B. Managerial Incentive Problems: A Dynamic Perspective. Review of
Economic Studies, 66, 1999
Dewatripont M., Jewitt I., Tirole J. Comparison of Information Structures. The Economics of
Career Concerns.Review of Economic Studies, 66:183-198, 1999
Dewatripont M., Jewitt I., Tirole J. Applications to Missions in Organizations . The
Economics of Career Concerns. Review of Economic Studies, 66: 199-217, 1999
Gibbons R., Murphy K.J. Optimal Incentive Contracts in the Presence of Career Concerns:
Theory and Evidence. Journal of Political Economy, 100:468-505, 1992
 Insurance
1. *(S) Chapter 5.4.1
2. Arrow K.J. Uncertainty and the Welfare Economics of Medical Care. American Economic
Review, 53:941-973, 1963
3. Arrow K.J. Insurance, Risk and Resource Allocation. in K.J. Arrow, ed., Essays in the
Theory of Risk Bearing, Chicago: Markham, 1971
4. Zeckhauser R.Medical Insurance: A Case Study of the Trade-Off Between Risk Spreading
and Appropriate Incentives. Journal of Economic Theory, 2:10-26, 1970
5. Ma, C.-t.A., McGuire T. Optimal Health Insurance and Provider Payment. American
Economic Review, 87:685-704, 1997
6. Ma, C.-t.A. Health Care Payment Systems: Cost and Quality Incentives. Journal of
Economics & Management Strategy, 3:93-112, 1994
7. McGuire T. Physician Agency in A.J. Culyer and J.P Newhouse, eds., Handbook of Health
Economics, Amsterdam: Elsevier Science, 2000
 Sharecropping
1. Stiglitz J. Incentives and Risk Sharing in Sharecropping, Review of Economic Studies,
41:219-256, 1974
V. Incomplete contracts
A. Theory
1 *(S) Chapter 7
2. (H) Chapters 2 and 3
3. (Section 3) Hart O., Holmstrom B.,1987
4. Grossman S.J., Hart O.D. The Costs and Benefits of Ownership: A Theory of Vertical and
Lateral Integration. Journal of Political Economy, 94:691-719, 1986
5. Hart O., Moore J. Incomplete Contracts and Renegotiation. Econometrica, 56:755-785, 1988
6. Hermalin B.E., Katz M.L. Moral Hazard and Veriability: The Effects of Renegotiation in
Agency. Econometrica, 59:1735-1753, 1991
7. Aghion P., Dewatripont M., Rey P. Renegotiation Design with Unveriable Information.
Econometrica, 62:257-282, 1994
B. Foundations and Critique
1. (H) Chapter 4
2. Hart O., Moore J. Foundations of Incomplete Contracts. Review of Economic Studies,
66:115-138, 1999
3. Maskin E., Tirole J. Unforeseen Contingencies and Incomplete Contracts. Review of
Economic Studies, 66:83-114, 1999
4. Anderlini L., Felli L. Incomplete Written Contracts: Undescribable States of Nature.
Quarterly Journal of Economics, 109:1085-1124, 1994
5. Survey: Tirole J. Incomplete Contracts: Where Do We Stand?. Econometrica, 67:741-781,
1994
6. *Bernheim B.D., Whinston M.D. Incomplete Contracts and Strategic Ambiguity. American
Economic Review, 88:902-932, 1998
C. Applications: Financial Contracting and the Theory of the Firm
1. (H) Chapter 1, 5-8
2. Survey: Holmstrom B., Tirole J. The Theory of the Firm in R. Schmalensee and R.D.
Willig, eds., Handbook of Industrial Organization, New York: Elsevier Science Publishers,
1989
3. Aghion P., Bolton P. An `Incomplete Contracts' Approach to Financial Contracting. Review
of Economic Studies, 59:473-494, 1992
4. Hart O., Moore J. A Theory of Debt Based on the Inalienability of Human Capital. Quarterly
Journal of Economics, 109:841-879, 1994
5. Hart O., Moore J. Default and Renegotiation: A Dynamic Model of Debt. Quarterly Journal
of Economics, 113:1-41, 1998