Ortmann, Andreas, and David Colander. "A Simple Principal-Agent Experiment for the Classroom." Economic Inquiry. 35 (April 1997) 443-450.
This classroom exercise illustrates the basic incentive conflicts in principal-agent interactions, the importance of information, and the power of reputational enforcement. Begin the demonstration by presenting the case: the agent is a seller of a good (hi-fi stereo high or computer repair), supplying either high or low quality repair. The principal is the buyer who must either verify the quality (at a cost) or trust the sellers promise to deliver high quality. Then discuss the dilemma the players face and how the collectively optimal decision will not (necessarily) be achieved by individual optimization. Select the participants (an even number of students10 to 20) and have them come to the front of the room. Give one half red paper, the other half blue. Explain that red paper means they are a buyer and blue paper means seller. Each participant should be given an initial one-quarter (actual coin $0.25) endowment. Sellers should write on a piece of paper whether they want to sell a high or low quality part. Buyers should write whether they will be checking the quality of the part. The students will receive the following payments: (1) if the seller ends up providing high quality and the buyer ends up not inspecting them they will both receive another quarter; (2) if the seller ends up providing low quality and the buyer ends up not inspection, the seller will receive an additional quarter and will also receive the buyers quarter; and (3) if the buyer has chosen to inspect, they both will get to keep their quarter regardless of the sellers decision. The participants walk randomly around the room until a buyer is paired with a seller. Once paired, they can discuss optimal strategy combination, but they must write down their choice privately. They write their names on the paper, fold it, and turn it in with their partners (in pairs). The students return to their seats and the outcomes recorded and money distributed. Discuss results. Game can be played in many rounds.