Economic Theory 17, 489496 (2001)

Ranking of information systems in agency models: an integral condition

Dominique Demougin1 and Claude Fluet2
1 2

Otto-von-Guericke Universit t, Universit tsplatz 2, 39106 Magdeburg, GERMANY a a (e-mail: demougin@ww.uni-magdeburg.de) ` Universit du Qu bec a Montr al, C.P. 8888, Montr al, H3C 3P8, CANADA e e e e (e-mail: uet.claude-denys@uqam.ca)

Received: November 10, 1999; revised version: February 17, 2000

Summary. We provide a condition for ranking of information systems in agency problems. The condition has a straightforward economic interpretation in terms of the sensitivity of a cumulative distribution with respect to the agents effort. The criterion is shown to be equivalent to the mean preserving spread condition on the likelihood ratio distributions. Keywords and Phrases: Moral hazard, Information systems. JEL Classication Numbers: D8.

1 Introduction This note presents a criterion to rank information systems in moral hazard environments. We consider systems with a sufcient statistic satisfying MLRP. Under the proposed criterion a statistic is more efcient than another if its cdf is more sensitive to the agents effort. We show that this condition, hereafter the integral criterion, is equivalent to Kims (1995) requirement in terms of mean preserving spreads of the likelihood ratio distributions (MPS-criterion). Holmstr m (1979) already suggested that in the moral hazard problem with o risk averse agents informativeness should be related to the variability of likelihood ratios. Kim (1995) formalized that intuition by proving that the MPScriterion is sufcient for ranking information systems. In a recent contribution,
The authors are thankful to Bertrand Koebel, Dirk Rathjen and Robert Schwager for insightful comments. Financial support from the Social Science and Humanity Research Council of Canada is gratefully acknowledged. Correspondence to: C. Fluet

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Jewitt (1997) extended the analysis by showing that MPS is also necessary under the rst-order approach. Furthermore, for information systems satisfying MLRP, Jewitt derived additional equivalence results with other statistical criteria. This note extends an idea developed for the risk-neutral agency framework in Demougin and Fluet (1998a). Under risk-neutrality, the optimal contract is a bonus scheme (see also Kim, 1997 and the references therein). An information system can then be shown to be better than another if the probability of getting a bonus is more sensitive to effort. With risk aversion, a similar intuition applies if the principal were to restrict herself to bonus contracts. Our contribution is to prove that, if an information system is better under any bonus scheme, then it is also better for the optimal contract. We further prove equivalence with MPS.

2 The integral criterion Consider the following moral hazard setting. The principal is risk neutral and the agent risk averse. The agent undertakes a non veriable effort on behalf of the principal. The agents preferences are represented by the utility function u(w) v(a), where w denotes payment, a A = [0, a] effort and u, v are strictly increasing and respectively concave and convex functions. For any a that is to be carried out, the principals problem is to minimize her expected costs. In what follows, we analyze the implementation costs for some effort level a. We consider information systems that can be represented by a random variable X over the support S X R, with density function f (x |a) and respective cumulative F (x |a). We impose standard regularity requirements, assuming the densities to be twice differentiable in effort with non-moving support. Assuming strict MLRP1 , we take as a convention that the cumulative distributions satisfy Fa (x |a) < 0. Given an information system X the principal who wants to implement a > 0 solves for the function w(x ) that minimizes expected costs: C P (a; F ) = min
w(x ) k

w(x )f (x |a) dx
SX

(I)

(i)
SX

u(w(x ))f (x |a) dx v(a) u(w(x ))fa (x |a) dx v (a)

SX

u = 0

(ii)

where u denotes the agents reservation utility and k is the lower bound on the agents payment.2 The constraints are respectively the agents participation and incentive compatibility conditions. The incentive constraint has been written
1 As is well known MLRP implies that the payment scheme is monotonic. Strict MLRP guarantees strict monotonicity, which simplies the exposition. 2 The bound can be interpreted as a limited liability constraint for the agent. As is well known from the literature, it also avoids non-existence problems.

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presuming the rst-order approach to the principals problem to be valid (see Rogerson, 1985). The notation C P (a; F ) reects the fact that the principals cost depends on her information system. The criterion which we introduce is dened in terms of the sensitivity of information systems. Heuristically, a system is said to be more sensitive than another if probabilities are more responsive to variations in effort. Integral Criterion. Let X and Y be two information systems with cumulative distributions F (x |a) and G(y|a), respectively. Then G is more efcient than F for implementing a if, for all realizations y and x such that G(y|a) = F (x |a), we have Ga (y|a) Fa (x |a) (1)

In the remaining we prove that the above condition generates a natural ranking in terms of implementation costs. Before doing so, we give a simple heuristic. Suppose contracts were restricted to be of the bonus type with T as the xed payment and t as the bonus. Assuming the principal initially uses the information system X , let z = F (x |a) denote some given probability that the agent does not obtain the bonus. The participation and incentive constraints then fully determine payments: u(T )F (x |a) + u(T + t)(1 F (x |a)) [u(T + t) u(T )]Fa (x |a) = u + v(a) (2) (3)

= v (a)

Is there a simple way for the principal to verify whether an alternative information system Y is better suited for her purpose? Suppose she were to switch from X to Y without changing the bonus probability. If the integral criterion holds [u(T + t) u(T )] must decrease. Since the agents expected utility remains the same and risk is lowered, it follows that expected implementation costs are smaller. If the same is true for any feasible probability z , then clearly G dominates F .

3 A sufciency proof We now show that the gist of the foregoing argument generalizes to the optimal contract. For that purpose, we introduce a standardization of information systems. Given system X , let: Z = F (X |a). (4)

Obviously, Z is a sufcient statistic which also satises MLRP. Its distribution is given by: Pr{F (X |a) z | a} = Pr{X = F 1 (z |a) | a} (5)

F [F 1 (z |a)|a].

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The transformation is useful because at a = a, Z is uniformly distributed on the unit interval as can be seen from (5).3 Without loss of generality, it is henceforth assumed that both systems are standardized at a. Consequently, z [0, 1], z = F (z |a) = G(z |a) (6)

and the integral criterion simplies to: z [0, 1], Ga (z |a) Fa (z |a) (7)

Altogether, these conditions can be represented geometrically as in Figure 1. The concavity of the curves follows directly from MLRP.

Figure 1. G is more efcient than F at a

The main advantage of standardization is that incentive properties of payment functions become easily comparable across information systems. Consider a payment schedule w(z ), z [0, 1]. If the agent undertakes the required effort, expected utility is the same under either information structure. However, for other effort levels this will in general not be true. Suppose w(z ) is the optimal payment schedule under F . From the agents rst-order condition at a, marginal benet of effort is just equal to marginal cost. Suppose now that G is more efcient than F for implementing a. Were the principal to keep w(z ) under G, the contract would provide too much incentives. Indeed, at a expected utility is the same under either F or G. By contrast, a small increase in effort to a + means that G(z |a +) dominates F (z |a +) in the sense of rst-order stochastic dominance, resulting in a greater marginal benet of effort at a under G. As a result, the principal can use a less powerful contract. This reduces risk and the required premium, thereby lowering implementation cost. Proposition 1. If G is more efcient than F at a, implementation costs for a are lower under G than under F . Proof. Let w(z ) be the solution of (I) under information system F . We rst prove that w(z ) generates too much incentives under G. From the incentive constraint under F , we have:
Perhaps a natural interpretation is to think of Z as a performance index calibrated with respect to the required effort.
3

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1

493

=
0

u(w(z ))fa (z |a) dz v (a)

1

0 1

u (w(z ))w (z )Fa (z |a) dz v (a) u (w(z ))w (z )Ga (z |a) dz v (a)
0 1

=
0

u(w(z ))ga (z |a) dz v (a)

where the second and the fourth equality follow from integration by part. The inequality results from (7) and the fact that w (z ) > 0 by strict MLRP. In order to prove C (a; G) C (a; F ), we construct a payment schedule under G that costs C (a; F ) and satises the participation and the incentive constraints. For that purpose, we rewrite the schedule implementing a under F as w(z ) = C (a; F ) + w1 (z ), where w1 (z ) can be interpreted as the variable portion of the payment scheme. By construction, it satises E [w1 (z )|a] = 0. Now, we dene a family of payment functions w(z , ) C (a; F ) + w1 (z ). From the point of view of the risk neutral principal all these schedules cost C (a; F ). For = 1 incentives are too strong. Conversely, for = 0 payments are constant and the agent would not undertake any effort. By continuity there must exist a (0, 1) that just provides correct incentives. For the payment schedule w(z , ), participation is also satised since the agent faces less risk ( < 1). This concludes the proof since C (a; G) E [w(z , )|a]. The derivation of the proof shows that the agents marginal benet can be written as the integral of the product dH du (w(z )) (z |a) , dz da with H = F or G. (8)

Now a more efcient information system increases the second term of the product for all z , thus, raising the agents incentives. In order to maintain incentives the principal must therefore reduce the rst term of (8). This diminishes risk allowing a reduction in premium, thereby decreasing the principals expected costs. 4 Equivalence with MPS We now prove equivalence between the integral and the MPS criterion introduced by Kim (1995). For completeness, we restate Kims result: MPS Criterion.Let X and Y be two information systems with cumulative distributions F (x |a) and G(y|a)respectively. Then G is more efcient than F for

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ga (Y |a) g(Y |a)

implementing a if the random variable

fa (X |a) f (X |a) .

is a mean preserving spread of

Without loss of generality we take the two information systems to be standardized at a. We start with a purely technical result. Lemma 2. Let Z be the standardized statistic at a with density h(z |a). Denote the cumulative of the likelihood ratio R ha (Z |a) by L(r|a). Then for any r in h the support 1 (9) L(r|a) = ha (r|a) . Proof. Due to standardization, h(z |a) = 1 for all z . Thus, at a = a, R = ha (Z |a) and L(r|a) Pr {ha (Z |a) = = Pr Z
1 ha (r|a) .

r | a} |a

1 ha (r|a)

The second step follows by strict MLRP so that the inverse exists. The last equality follows from the uniform distribution of Z at a.

Figure 2. Likelihood ratio distribution functions

Applying the lemma, we represent in Figure 2 the likelihood ratio distributions of two information systems. Geometrically, MPS states that G dominates F 1 at a if for all r the area under the curve ga is never smaller than that under fa1 . By contrast, the integral criterion is written in terms of fa and ga . Geometrically, it states that G dominates F at a if for all z along the vertical axis the area under one curve is never smaller than that under the other. This corresponds to an area as obtained through horizontal integration. We now formalize the argument. Proposition 3. G dominates F for implementing a according to the MPS crite rion if and only if the same also holds according to the integral criterion.

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Proof. From the denition of stochastic dominance, MPS necessitates:

r

r R,

T (r) =

1 [ga (q|a) fa1 (q|a)] dq

0.

The integral criterion requires:

z

z [0, 1],

S (z ) =
0

[ga (s|a) fa (s|a)] ds

0.

Due to the symmetry, we show that MPS implies the integral criterion and leave the converse to the reader. Assume MPS holds. Consider pairs (ri , zi ) that satisfy
1 fa1 (ri |a) = ga (ri |a) = zi .

As can be seen from Figure 2, for these points T (ri ) = S (zi ). Hence by MPS T (ri ) 0 which implies S (zi ) 0. Now consider any z (zi , zi +1 ). From the gure, either [ga (z |a)fa (z |a)] 0 over the entire interval or it is negative over the interval. If it is negative, we write
z

S (z ) = S (zi ) +
zi

[ga (s|a) fa (s|a)] ds

0.

If on the contrary it is positive, then we write: S (z ) = S (zi +1 )

z zi +1

[ga (s|a) fa (s|a)] ds

0.

Jewitt (1997) obtains a similar result on the basis of Atkinsons (1970) ndings on the relationship between mean preserving spreads and Lorenz curves.

5 Concluding remarks For brevity, we have restricted the above analysis to the case of information systems dened in terms of scalar random variables satisfying MLRP. As shown in an earlier version (see Demougin and Fluet, 1998b) the results easily generalize. The intuition for such an extension is that the likelihood ratio of a random variable is a scalar statistic incorporating all the information relevant to a principal in a moral hazard framework.4 Furthermore, it is easily shown that such a statistic satises a local version of MLRP, which is all that is truly needed to generalize the foregoing analysis.
This follows immediately from the rst-order condition of the principals problem (see e.g. Holmstr m (1979)). o
4

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References
Atkinson, A. B.: On the measurement of inequalities. Journal of Economic Theory 2, 24463 (1970) Demougin, D., Fluet, C.: Mechanism sufcient statistic in the risk-neutral agency problem. Journal of Institutional and Theoretical Economics 154 (4), 622639 (1998a) Demougin, D., Fluet, C.: Ranking of information systems in agency models: an integral condition. Discussion Paper of the Faculty of Economics and Management at Magdeburg 29 (1998b) Holmstr m, B.: Moral hazard and observability. Bell Journal of Economics 10, 7491 (1979) o Jewitt, I.: Information and principal-agent problems. Mimeo, University of Bristol (1997) Kim, S. K.: Efciency of an information system in an agency model. Econometrica 63, 89102 (1995) Kim, S. K.: Limited liability and bonus contracts. Journal of Economics and Management Strategy 6, 899913 (1997) Rogerson, W.: The rst-order approach to principal-agent problems. Econometrica 53, 13571367 (1985)