Econ 441-01

Economics of Incentives

Professor: Douglas Nelson

Office: Tilton 108 (Murphy Institute), Phone: 865-5317

Office Hours: Tuesday and Thursday, 3:30-5:30

Phone: 865-5317



We often say that microeconomics deals with incentives. However, in much of undergraduate microeconomics, by assuming that agents (firms, households, etc.) are small in the relevant markets, we are able to characterize choice in ways that seem strangely asocial. Agents do not so much interact with each other as they respond to impersonal (primarily price) signals. As a result, incentive issues do not arise in a serious way. While much of our economic life is well-understood through such models, there are large parts of our economic life in which we have some market power due to the fact that we have private information. The purpose of this course is to extend the tools developed in intermediate microeconomics to a variety of (primarily economic) situations in which at least some agents possess private information and examine the kinds of mechanisms that exist to deal with the problems created by such private information. Among the situations we will examine are: the relations between managers and employees; the relations between stockholders and mangers; the relations between insurance companies and potential clients; the relations between sellers and buyers of used cars; provision of public goods; and many more. In all of these cases the existence of private information, along with self-interested behavior on the part of all agents, can result in the failure of agents to make mutually beneficial contracts. Thus, in all of these cases we will first seek to characterize the relationship in such a way that the effect of private information becomes clear, and then we will seek to understand the social institutions that help us overcome these problems. Our strategy will be to focus on the main principles by studying examples, not by seeking to prove very general results.

These issues are at the frontier of modern microeconomic and political-economic research. While we will not pursue a rigorous theorem-proof approach, this is a course in economic theory. Intermediate microeconomics (Economics 301) is a serious prerequisite. Although we will be working with illustrative examples, we will be using logic, algebra, geometry, and simple calculus extensively.

The main text for the course is:


Donald Campbell (2006). Incentives: Motivation and the Economics of Information (2nd ed.). New York: Cambridge University Press.

We will draw supplementary reading from a variety of journal articles.

Those interested in somewhat more advanced material on the topics of this course can refer to:


Inés Macho-Stadler and David Pérez-Castrillo (1997). An Introduction to the Economics of Information: Incentives & Contracts. New York: Oxford University Press.


Ian Molho (1997). The Economics of Information: Lying and Cheating in Markets and Organizations. Oxford: Blackwell.


Bernard Salanié (1997). The Economics of Contracts: A Primer. Cambridge: MIT.


Vijay Krishna (2002). Auction Theory. San Diego: Academic Press.


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


Patrick Bolton and Mathias Dewatripont (2005). Contract Theory. Cambridge: MIT Press.


Jean Tirole (2006). The Theory of Corporate Finance. Princeton: PUP.

Other interesting and useful references are:


John Abowd and David Kaplan (1999). “Executive Compensation: Six Questions That Need Answering”. Journal of Economic Perspectives; V.13-#4, pp. 145-168.


Oliver Hart (1995). Firms, Contracts, and Financial Structure. Oxford: OUP.


Oliver Hart and Bengt Holmstrom (1987). “The Theory of Contracts”. In Truman Bewley, ed. Advances in Economic Theory (5th World Congress). Cambridge: CUP, pp. 71-155.


Jack Hirshleifer and John Riley (1992). The Analytics of Uncertainty and Information. Cambridge: CUP.


Bengt Holmstrom and Steven Kaplan (2001). “Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s”. Journal of Economic Perspectives; V.15-#2, pp. 121-144.


Bengt Holmstrom and John Roberts (1998). “The Boundaries of the Firm Revisited”. Journal of Economic Perspectives; V.12-#4, pp. 73-94.


Michael Jensen and W.H. Meckling (1976). “Theory of the Firm: Managerial Behavior, Agency Cost, and Ownership Structure”. Journal of Financial Economics; V.11-#4, pp. 304-360.


Paul Milgrom and John Roberts (1992). Economics, Organization and Management. Englewood Cliffs, NJ: Prentice-Hall.


Gary Miller (1992). Managerial Dilemmas: The Political Economy of Hierarchy. Cambridge: CUP.


Canice Prendergast (1999). “The Provision of Incentives in Firms”. Journal of Economic Literature; V.37-#1, pp. 7-63.


Oliver Williamson (1975). Markets and Hierarchies. New York: Free Press.


Oliver Williamson (1985). The Economic Institutions of Capitalism. New York: Free Press.

Your performance in the course will be evaluated on the basis of a two mid-term examinations a final examination, and a large number of homework assignments. The midterms will be given on 27 September and 25 October, and the final exam will be given only on Saturday, 15 December 2007, 1:00pm. Because much of the course will involve discussion of the reading and the homework, attendance is mandatory, as is timely completion of homework.

Econ 441                                        SYLLABUS                                   Fall 2007

Topic I. Review of Microeconomics


● 8/30-9/4, Course Overview


■ Campbell, Cptr. 1.1-1.4


● 9/6-9/11, Game Theory


■ Campbell, Cptr. 1.5-1.6


■ Gibbons (1997). “An Introduction to Applicable Game Theory”. Journal of Economic Perspectives; V.11-#1, pp. 127-149.


● 9/13, Demand Theory: Preference, Rationality, and Choice


■ Campbell, Cptr. 2.1-2.3


● 9.18, Special Topics in Demand Theory: Making our Lives Easier


■ Campbell, Cptr 2.4-2.5


● 9/20-9/25, Decision-making under Uncertainty


■ Campbell, Cptr. 2.6-2.7.


■ Hirshleifer and Riley (1992). “Elements of Decision under Uncertainty”. Chapter 1 of The Analytics of Uncertainty and Information. Cambridge: CUP, pp. 7-29. [ERes]

Midterm 1: 27 September.

Topic II. Hidden Action


● 10/2, Introduction


■ Campbell, Cptr. 3, sections 1-8


● 10/18, Insurance and Moral Hazard


■ Campbell, Cptr. 3, section 9


■ Arnott and Stiglitz (1988). “The Basic Analytics of Moral Hazard”. Scandinavian Journal of Economics; V.90-#3, pp. 383-413. [optional]


● 10/23, Basic Economics of Corporate Governance


■ Campbell, Cptr. 4, sections 1-3


■ Alchian and Demsetz (1972). “Production, Information Costs, and Economic Organization”. American Economic Review; V.62-#5, pp. 777-795.


● 10/25-10/30, The Principal-Agent Model


■ Campbell, Cptr. 4, sections 4 & 5


■ Sappington (1991). “Incentives in Principal-Agent Relationships”. Journal of Economic Perspectives; V.5-#2, pp. 45-66.


■ Gibbons (1998). “Incentives in Organizations”. Journal of Economic Perspectives; V.12-#4, pp. 115-132.

Midterm 2: 1 November.

Topic III. Hidden Characteristics


● 11/6, Responding to Hidden Information: On Mechanisms, Revelation Principle, and Design


■ Campbell, Cptr. 5, section 1 and 2


● 11/8, Sellers with Private Information, 1: Lemons


■ Campbell, Cptr. 5, section 3.


■ Akerlof (1970). “The Market For Lemons: Quality Uncertainty and the Market Mechanism”. Quarterly Journal of Economics; V.84-#3, pp. 488-500.


● Optional Topic: Credit Rationing


■ Campbell, Chapter 5, section 4


● Optional Topic, Quality and the Firm: Choosing and Pricing Quality


■ Campbell, Cptr. 5, section 5.


■ Bagwell and Riordan (1991). “High and Declining Prices Signal Product Quality”. American Economic Review; V.81-#1, pp. 2245-239.


● 11/13-11/15, Sellers with Private Information, 2: Job Market Signaling and Screening


■ Campbell, Cptr. 5, section 6.


■ Riley (2001). “Silver Signals: Twenty Five Years of Screening and Signaling”. Journal of Economic Literature; V.39-#2, pp. 432-478. [especially sections 2.6-3 and 5 (pp. 438-451 and 459-467).]


■ Spence (1973). “Job Market Signalling”. Quarterly Journal of Economics; V.87-#3, pp. 355-374.


■ Stiglitz (1975). “The Theory of ‘Screening’, Education, and the Distribution of Income”. American Economic Review; V.65-#3, pp. 283-300.


● 11/20-11/27, The Economics of Adverse Selection in Insurance Markets


■ Campbell, Cptr. 5, section 7


■ Riley (2001). “Silver Signals: Twenty Five Years of Screening and Signaling”. Journal of Economic Literature; V.39-#2, pp. 432-478. [sections 1-2.5 (432-438).]


■ Rothschild and Stiglitz (1976). “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information”. Quarterly Journal of Economics; V.90-#4, pp. 629-649.


● 11/29-12/6, Applying the Mechanism/Design Approach: An Introduction to Auctions Theory


■ Campbell, Cptr. 6.


■ Milgrom (1989). “Auctions and Bidding: A Primer”. Journal of Economic Perspectives; V.3-#3, pp. 3-32.


■ McMillan (1994). “Selling Spectrum Rights”. Journal of Economic Perspectives; V.8-#3, pp. 145-162.


■ McAfee and McMillan (1996). “Analyzing the Airwaves Auction”. Journal of Economic Perspectives; V.10-#1, pp. 159-175.


■ Binmore and Klemperer (2002). “The Biggest Auction Ever: The Sale of the British 3G Licenses”. Economic Journal; V.112-#478, pp. C74-C96.


■ Klemperer (2002). “What Really Matters in Auction Design”. Journal of Economic Perspectives; V.16-#1, pp. 169-189.


■ Ashenfelter (1989). “How Auctions Work for Wine and Art”. Journal of Economic Perspectives; V.3-#3, pp. 23-36.


■ Lucking-Reiley (2000). “Vickery Auctions in Practice: From Nineteenth Century Philately to Twenty-first Century E-commerce”. Journal of Economic Perspectives; V.14-#3, pp. 183-192.

Final Examination: Monday, 15 December, 1:00pm.

Topic IV. Reputation


■ Campbell, Cptr. 1.7


■ Kreps, Milgrom, Roberts, and Wilson (1982). “Rational Cooperation in the Finitely Repeated Prisoners’ Dilemma”. Journal of Economic Theory; V.27-#2, pp. 245-252.

Topic V. General Equilibrium and the Efficiency of Perfect Competition


■ Campbell, Cptr. 10.1-10.3


■ Arrow (1974). “General Economic Equilibrium: Purpose, Analytic Techniques, Collective Choice” (Nobel Prize Lecture). American Economic Review; V.64-#3, pp. 253-272.

Topic VI. Resource Allocation: Private Goods


■ Campbell, Cptr. 10.4


■ Hurwicz (1973). “The Design of Resource Allocation Mechanisms”. American Economic Review; V.58-#2, pp. 1-30.

Topic VII. Voting and Preference Revelation: The Gibbard-Satterthwaite theorem


■ Campbell, Cptr. 7


■ Feldman (1979). “Manipulating Voting Procedures”. Economic Inquiry; V.17-#?, pp. 452-474

Topic VIII. Resource Allocation: Public Goods


■ Campbell, Cptr. 8.


■ Sonnenschein (1998). “The Economics of Incentives: An Introductory Account”. in D. Jacobs, E. Kalai, and M. Kamien, eds. Frontiers of Research in Economic Theory: The Nancy L. Schwartz Memorial Lectures, 1983-1997. New York: Cambridge University Press, pp. 3-15.

Topic IX. Matching


■ Campbell, Cptr. 9.