The Theory of Incentives

xi Foreword
Introduction 1
1 Incentives in Economic Thought 7
1.1 Adam Smith and Incentive Contracts in Agriculture 8
1.2 Chester Barnard and Incentives in Management 11
1.3 Hume, Wicksell, Groves: The Free-Rider Problem 14
1.4 Borda, Bowen, Vickrey: Incentives in Voting 15
1.5 Leon Walras and the Regulation of Natural Monopolies 18
1.6 Knight, Arrow, Pauly: Incentives in Insurance 18
1.7 Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives 20
1.8 Dupuit, Edgeworth, Pigou: Price Discrimination 22
1.9 Incentives in Planned Economies 23
1.10 Leonid Hurwicz and Mechanism Design 25
1.11 Auctions 27
2 The Rent Extraction-Efficiency Trade-Off 28
2.1 The Basic Model 32
2.2 The Complete Information Optimal Contract 33
2.3 Incentive Feasible Menu of Contracts 36
2.4 Information Rents 39
2.5 The Optimization Program of the Principal 40
2.6 The Rent Extraction-Efficiency Trade-Off 41
2.7 The Theory of the Firm Under Asymmetric Information 46
2.8 Asymmetric Information and Marginal Cost Pricing 48
2.9 The Revelation Principle 48
2.10 A More General Utility Function for the Agent 51
2.11 Ex Ante versus Ex Post Participation Constraints 57
2.12 Commitment 63
2.13 Stochastic Mechanisms 65
2.14 Informative Signals to Improve Contracting 68
2.15 Contract Theory at Work 72
Appendix 81
3 Incentive and Participation Constraints with Adverse Selection 82
3.1 More than Two Types 86
3.2 Multidimensional Asymmetric Information 93
3.3 Type-Dependent Participation Constraint and Countervailing Incentives 101
3.4 Random Participation Constraint 115
3.5 Limited Liability 118
3.6 Audit Mechanisms and Costly State Verification 121
3.7 Redistributive Concerns and the Efficiency-Equity Trade-Off
134 Appendices 130
4 Moral Hazard: The Basic Trade-Offs 145
4.1 The Model 148
4.2 Risk Neutrality and First-Best Implementation 153
4.3 The Trade-Off Between Limited Liability Rent Extraction and Efficiency 155

Jean-Jacques Laffont is Professor of Economics at the University of Toulouse and at the University of Southern California. He has published extensively in public economics, incentive theory, development economics and economics of regulation.

The most important development in economics in the last forty years has been the study of incentives to achieve potential mutual gains when the parties have different degrees of knowledge. The time is ripe for a synthesis and systematization. Jean-Jacques Laffont has been one of the most important contributors to the field over the years, and David Martimort has shown his capacity for highly original work. This book, dealing with the basic models of the field, combines clarity, thoroughness, and great respect for historical development.