The Review of Economic Studies has instituted a new series of lectures to be given annually by a "younger" British economist at the Association of University Teachers of Economics Meetings. The choice of lecturer is determined by a panel whose members are currently Professors Hahn, Mirrlees and Nobay. This paper is a revised version of the first lecture in the series. It was presented at the AUTE Meeting held at the University of Surrey in April 1982, and was refereed in the usual way.—MAK.

Most analyses of the principal-agent problem assume that the principal chooses an incentive scheme to maximize expected utility subject to the agent's utility being at a stationary point.An important paper of Mirrlees has shown that this approach is generally invalid.We present an alternative procedure.If the agent's preferences over income lotteries are independent of action, we show that the optimal way of implementing an action by the agent can be found by solving a convex programming problem.We use this to characterize the optimal incentive scheme and to analyze the determinants of the seriousness of an incentive problem.'Support from the U.K.

A general equilibrium model of optimal employment contracts is developed where firms have better information about labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from falsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustry shift in labor demand and that would have no effect on total employment under symmetric information leads to a reduction in employment when firms and workers have asymmetric information.

A general equilibrium model of optimal employment contracts is developed where firms have better information about labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from falsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustry shift in labor demand and that would have no effect on total employment under symmetric information leads to a reduction in employment when firms and workers have asymmetric information.