We consider a principal–agent model of adverse selection where, in order to trade with the principal, the agent must undertake a relationship-specific investment which affects his outside option to trade, i.e. the payoff that he can obtain by trading with an alternative principal. This creates a distinction between the agent's ex ante (before investment) and ex post (after investment) outside options to trade. We investigate the consequences of this distinction, and show that whenever an agent's ex ante and ex post outside options differ, this may equip the principal with an additional tool for screening among different agent types, by randomizing over the probability with which trade occurs once the agent has undertaken the investment. In turn, this may enhance the efficiency of the optimal second-best contract.
Authors
CPP Director, IFS Research Director
Imran is Professor of Economics at University College London and Director of the Centre for the Microeconomic Analysis of Public Policy at the IFS.
Silvia Sonderegger
Journal article details
- DOI
- 10.1016/j.geb.2009.10.006
- Publisher
- Elsevier
- JEL
- D21, L14
- Issue
- Volume 68, Issue 2, March 2010, pages 781-788
Suggested citation
Rasul, I and Sonderegger, S. (2010). 'The role of the agent's outside options in principal–agent relationships' 68, Issue 2(2010), pp.781–788.
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