Topics of Principal-Agent Contracts: Contract Analysis and Pooling Principals

Abstract

Consider companies who rely on revenue generating equipment that fails from time to time. Assume that a company owns one unit of equipment, whose maintenance and repair services are outsourced to a qualified service provider. We assume that the company (the principal) outsources the maintenance and repair services using performance based contracts. Such contractual relationships fall into economics' principal-agent framework. The owners of the revenue generating units are referred to as principals, and the service provider as the agent. We address the following questions: What are the optimal contracting strategies for a principal and an agent? Can the agent benefit from pooling the service demands from multiple principals? This dissertation contains two main bodies of work contained in chapters 2-7 and chapters 8-13 respectively. In the first part of this dissertation (chapters 2-7) we examine the contractual options between a single principal and a single agent. The contractual options of a principal and an agent are modeled as a Markov process with an undetermined time horizon. For a risk neutral principal we identify the conditions under which a principal contracts with a risk-neutral, risk-averse, or risk-seeking agent and derive the principal's optimal offer and the agent's service capacity response. In essence, we provide an extensive formulating analysis of principal-agent contracts given any exogenous parameter values. That is, we derive mathematical formulas for the optimal contract offers and the agent's optimal service capacity. It turns out that a small number of formulas cover a large spectrum of principal-agent conditions. In the second part of this dissertation (chapters 8-13), in a counter distinction to the vast literature in economics on principal-agent contractual interplay and its predominant concern with the principal, here we focus on the agent. In the case of performance based service contracts it is known that the principal extracts all the economic surplus and the agent breaks even. But this is not the case for an agent of good standing contracting with multiple principals. We show that an agent who contracts a collection of principals with interdependent failure characteristics does better than break-even - such an agent realizes a profit rate that is convexly increasing in the number of principals. The corresponding cooperative game assessing each principal's contribution to the agent's profit is convex and its easily computable Louderback's value seems always to be in its core. In chapter 14 we present the outline of a future study that compares several different options of contract structure faced by the principal and the agent, because the optimal contracting strategies for the principal and the agent may not necessarily be the same under different contract structures. We discuss briefly the agent's and the principal's behavior under different forms of performance based contract, which serves as a starting point for future extensions of this dissertation. To summarize, this dissertation provides practical mathematical results and important managerial insights into the principal-agent contract in equipment repair services industry.