The Theory of Incentives

Introduction:

“The Theory of Incentives” by Jean Jacques Laffont and David Martimort is a comprehensive textbook that provides an introduction to the theory of incentives. The book is divided into three volumes, with the first volume covering the basic concepts and tools of the theory of incentives. The book is intended for undergraduate and first-year graduate students in economics who want to learn about incentive theory.

Overview of the Book:

The first volume of “The Theory of Incentives” provides an in-depth analysis of the principal-agent model, which is a fundamental tool for studying incentive problems. The authors explain how incentives can be used to align the interests of agents with those of principals. The book also covers moral hazard, adverse selection, and screening. The authors use simple models to explain the core concepts of the theory and provide numerous examples to illustrate the applications of the theory.

Principal-Agent Model:

The principal-agent model is a central focus of the book. The authors explain the basic model, including how the principal can design incentives to motivate the agent to take actions that benefit the principal. The book covers various types of contracts, including linear contracts and contracts that involve risk-sharing. The authors also explain how to incorporate multiple principals and agents into the model.

Moral Hazard:

Moral hazard is an important concept in the theory of incentives. The authors explain how moral hazard arises when the actions of the agent are not perfectly observable by the principal. They provide numerous examples, such as the problem of effort exertion in the workplace. The authors also discuss how to design contracts that mitigate moral hazard, such as performance-based contracts.

Adverse Selection:

Adverse selection is another important concept in the theory of incentives. The authors explain how adverse selection arises when agents have private information that is not known to the principal. They provide examples, such as the problem of selecting workers with different levels of ability. The authors also explain how to design contracts that mitigate adverse selection, such as screening contracts.

Screening:

Screening is a key tool for designing contracts that mitigate adverse selection. The authors explain how screening contracts can be use to extract information from agents and separate them into different types. They provide numerous examples, such as insurance markets, where individuals with different risk profiles are charge different premiums.

Applications of Incentive Theory:

The second volume of the book focuses on the applications of incentive theory in various fields of economics. The authors provide examples of how incentive theory can be use to analyze labor markets, corporate finance, and public economics. They also discuss how to use the theory to design optimal contracts in these settings.

Advanced Topics:

The third volume of the book explores advanced topics in the theory of incentives. The authors cover topics such as mechanism design, auctions, and repeated games. They provide a more technical treatment of these topics and assume that the reader has a solid understanding of the basic concepts covered in the first volume.

Conclusion:

Overall, “The Theory of Incentives” is an excellent textbook that provides a comprehensive introduction to the theory of incentives. The authors use simple models to explain the core concepts of the theory and provide numerous examples to illustrate their applications. The book is well-organize, with each chapter building on the previous one. The book is highly recommend for undergraduate and first-year graduate students in economics who want to learn about incentive theory. The book would also be useful for researchers who want to expand their knowledge of the theory of incentives.