Information Rents

To understand the structure of the optimal contract it is useful to introduce the concept of information rent. We saw in section 2.2 that, under complete information, the principal (who has all the bargaining power by assumption) is able to maintain all types of agents at  their  zero  status  quo  utility  level.  Their  respective

The Optimization Program of the Principal

According to our timing of the contractual game, the principal must offer a menu of contracts before knowing which type of agent he is facing. Therefore, he will compute  the  benefit  of  any  menu  of  contracts   in  expected  terms. The principal’s problem writes as Using the definition of the information rents , we can

The Rent Extraction-Efficiency Trade-Off

1. The Optimal Contract Under Asymmetric Information  The major technical difficulty of problem jP k, and more generally of incentive theory, is to determine which of the many constraints imposed by incentive com- patibility and participation are the relevant ones, i.e., the binding ones at the optimum of the principal’s problem. A first approach

The Theory of the Firm Under Asymmetric Information

When the delegation of task occurs within the firm, a major conclusion of the above analysis is that, because of asymmetric information, the firm does not max- imize the social value of trade, or more precisely its profit—a maintained assump- tion of most economic theory. This lack of allocative efficiency should not be considered

Asymmetric Information and Marginal Cost Pricing

Let us view the principal as acting for a set of consumers and the agent as a firm producing a consumption good. The first-best rules defined by (2.4) and (2.5) can be interpreted as price equal to marginal cost since consumers on the market will equate their marginal utility of consumption to price. Under

The Rent Extraction-Efficiency Trade-Off: The Revelation Principle

In the above analysis, we have restricted the principal to offer a menu of con- tracts, one for each possible type. First, one may wonder if a better outcome could be achieved with a more complex contract allowing the agent possibly to choose among more options. Second, one may also wonder whether some sort

A More General Utility Function for the Agent

Still keeping quasi-linear utility functions, let  U  = t − C(q,θ) now be the agent’s objective  function  with  the  assumptions: Cq > 0, Cθ > 0, Cqq > 0   and Cqqθ > 0. The  generalization  of  the  Spence-Mirrlees  property  used  so  far  is  now Cqθ > 0. This latter condition still ensures that

Ex Ante versus Ex Post Participation Constraints

As we have already mentioned, in most of our discussion dealing with the case of adverse selection, we consider the case of contracts offered at the interim stage, i.e., once the agent already knows his type. However, sometimes the principal and the agent can contract at the ex ante stage, i.e., before the agent

Commitment

To solve our incentive problem, we have implicitly assumed that the principal has a strong ability to commit himself not only to a distribution of rents that will induce information revelation but also to some allocative inefficiency designed to reduce the cost of this revelation. Alternatively, this assumption also means that the court of

Stochastic Mechanisms

We consider here the framework of section 2.10 with a general cost function C(q, θ).  Let  us  rewrite  the  principal’s  problem  as When  S(·) is  concave  and  C(·) is  convex,  the  principal’s  objective  function is  concave  in  (q, q¯, U , U¯).  Neglecting  constraints  (2.78)  and  (2.79)  as  usual,  the remaining constraints (2.77) and

Informative Signals to Improve Contracting

In this section, we investigate the impacts of various improvements of the prin- cipal’s information system on the optimal contract. The idea here is to see how signals that are exogenous to the relationship can be used by the principal to bet- ter design the contract with the agent. The simple observation of performances

Contract Theory at Work

This section proposes several classical settings where the basic model of this chap- ter is useful. Introducing adverse selection in each of these contexts has proved to be a significative improvement of standard microeconomic analysis. 1. Regulation  In the Baron and Myerson (1982) regulation model, the principal is a regulator who maximizes a weighted

Incentive and Participation Constraints with Adverse Selection

The main theme of chapter 2 was to determine how the fundamental conflict between rent extraction and efficiency could be solved in a principal-agent rela- tionship with adverse selection. In the models presented in chapter 2, this conflict was relatively easy to understand because it resulted from the simple interaction of a single incentive

Adverse Selection: More than Two Types

Suppose  that  θ may  take  three  possible  values,  i.e., ,  with for simplicity, and with respective probabilities v, vˆ, and v¯ such that . We denote a truthful direct revelation mechanism in this three-type environment  by .  Using  similar  notations,  information  rents write  respectively  as   and   As  a  benchmark, note that the

Adverse Selection: Multidimensional Asymmetric Information

Another important limitation of our analysis of adverse selection in chapter 2 is that the adverse selection parameter θ was modeled as a unidimensional parameter. In many instances, the agent simultaneously knows several pieces of information that are payoff relevant and affect the optimal trade. For instance, a tax authority would like to know

Adverse Selection: Type-Dependent Participation Constraint and Countervailing Incentives

The models in sections 3.1 and 3.2 have already illustrated the difficulties that the modeler faces when there is no obvious order between the various incen- tive constraints. The same kind of difficulties arise when the agent’s participa- tion constraint is type-dependent. Indeed, those participation constraints may also perturb the natural ordering of the

Adverse Selection: Random Participation Constraint

The previous section has shown how a deterministic but type-dependent participa- tion constraint could perturb the standard results on the optimal rent extraction- efficiency trade-off. We now perturb the agent’s participation constraint in another direction, by allowing some randomness in the decision to participate. Instead of the agent’s reservation utility being perfectly known, let

Adverse Selection: Limited Liability

Sometimes the set of incentive-feasible contracts is constrained by some exogenous limits on the feasible transfers between the principal and the agent. These exoge- nous financial constraints could reveal the existence of previous financial contracts that the agent might have already signed. Those constraints will of course affect the usual rent-efficiency trade-off. A first

Adverse Selection: Audit Mechanisms and Costly State Verification

Sometimes the principal would like to relax the efficient type’s incentive constraint by making it somewhat costly for him to lie and claim that he is inefficient. One important way to do so is by using an audit technology that can detect the agent’s nontruthful report and allows for some punishment when a false

Adverse Selection: Redistributive Concerns and the Efficiency-Equity Trade-Off

In the rent extraction-efficiency trade-off analyzed so far, the principal wants to minimize the information rent left to the agent for a given level of output. The principal has no redistributive concerns vis-à-vis the agent. In the optimal tax-ation literature, starting with the seminal paper of Mirrlees (1971),22 the principal (generally a government or