Models are easy to construct, but they may not always exactly match reality. While we assume that firms maximize profits, this may not always be true, and in this lecture we start to learn why. We also start to think about how we can measure the welfare that consumers gain from participating in a market.
Stocks and stock options are commonly used to overcome the agency problem. Image courtesy of Lance Ball on Flickr.
Keywords: Agency problem; corporations; stock options; normative economics; welfare economics; consumer surplus.
Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:
- [Perloff] Chapter 8, “Competitive Firms and Markets.” (optional)
This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.
Which of the following is NOT an example of the agency problem?
The other two options are both examples of the agency problem. When it is hard to observe managers' actions, and their pay is not fully tied to performance, they may not maximize profits. However, when a company hires workers to expand its business but lacks equipment for them to work on, the resulting issue is not relevant to the agency problem. Rather, it is an example of suboptimal balance between labor and capital.
What is a strategy that can be used to align the incentives of managers and owners in a given company?
Providing the managers with stocks or stock options gives them an incentive to raise shareholder value, because they will also benefit from higher value. Raising their salary, on the other hand, does not change their incentives.
What is the definition of consumer surplus?
The area above the supply curve below the price line is producer surplus, and the sum of the area above the supply curve below the price line and the area below the demand curve above the price line is total surplus.
Assume a consumer bought two concert tickets, and valued the first ticket at $50 and the second ticket at $30. The price of both tickets was $30. What is the consumer surplus for this consumer in the transaction?
The consumer gained no consumer surplus on the last ticket, since the price was equal to his valuation of the ticket. However, the surplus on the first ticket purchased was $20.