Lect301 2 PDF

Leonardo Felli 3 December, 2001
Advanced Economic Analysis Lecture 2
Consider now a moral hazard problem involving a

strictly risk-averse agent with CARA utility:
U (x, a) = −e−r(x−φ(a))
Recall that the index of absolute risk aversion is

then constant:
∂ 2U (x, a)/∂x2
r=−
∂U (x, a)/∂x
Let the outcome y be such that
y = a + ε, ε ∼ N (0, σ 2)
1
Advanced Economic Analysis 2
The cost of effort is quadratic:

a2
φ(a) =
2
and we normalize U = 1.
Restrict now the principal to offer only linear con-

tracts:
w(q) = β q + γ
Recall also that if
x̃ ∼ N (µ, σ 2)
then:
µ t+ 21 σ 2 t2
t x̃
Ex̃ e = e
First best contract is the solution to the following

problem:
max Ey [y − β y − γ]
w(·),â
h i
s.t. Ey −e−r(β y+γ−φ(â)) ≥ 1
Notice that:
h i h i
Ey −e−r(β y+γ−φ(â)) = Ey −e−r(β a+β ε+γ−φ(a)) =
−r(β a+γ−φ(a))+ 21 β 2 r2 σ 2
= −e
We can then rewrite the problem as:
max a − βa − γ
β,γ,a
a2 r 2 2
s.t. βa+γ− − β σ ≥0
2 2
Since the objective function is monotonic decreasing

in γ while the constraint is monotonic increasing in
γ we conclude:
a2 r 2 2
βa+γ− − β σ =0
2 2
Solving for γ we have:

a2 r 2 2
γ = + β σ −βa
2 2
Substituting we get:
a2 r 2 2
max a − − β σ
β,a 2 2
The solution is then:

1
β ∗ = 0, a∗ = 1, γ∗ =
2
This implies:
• effort choice
a∗ = 1
• transfer to the agent

1
w∗ =
2
for every y, full insurance.
• expected profit of the principal

∗ 1
Π =
2
Assume now that the agent’s effort a cannot be in-

cluded in a contract.
The agent then chooses â so as to maximize her own

expected utility:
h i
−r(β y+γ−φ(a))
â ∈ argmax Ey −e
a
Second best problem is then:
max Ey [y − β y − γ]
w(·),â
h i
s.t. Ey −e−r(β y+γ−φ(â)) ≥ 1
h i
−r(β y+γ−φ(a))
â ∈ argmax Ey −e
a
Therefore the agent’s incentive problem is then:

a2 r 2 2
â ∈ argmax β a + γ − − β σ
a 2 2
The unique solution to this problem is then
â = β
Then the second best problem becomes:
max â − â2 − γ
γ,â
2
2 â r 2 2
s.t. â + γ − − â σ ≥ 0
2 2
The solution is then:

1 r σ2 − 1
â = β = , γ=
1 + r σ2 2 (1 + r σ 2)2
Moreover:
1
â < a∗, Π= < Π ∗
2 (1 + r σ 2)
Tradeoff: between incentives (need for risk in the

remuneration) and insurance (need to reduce risk).
If the agent becomes less risk averse, r decreases, the

tradeoff is less strong and hence the agent’s effort is
closer to first best and the principal profits are higher.
The same conclusion apply if y becomes a better sig-

nal for a: σ 2 decreases.
In both these cases the power of the optimal incentive

scheme increases: higher β.
Hidden Information
Static Adverse Selection problem: one principal

facing one agent who has private information on his
type (preferences, intrinsic productivity).
We consider a monopolist’s pricing model: a trans-

action between a buyer (the agent) and a seller (the
principal).
The seller sets the terms of the contract.
The seller does not know how much the buyer is

willing to pay for the commodity.
The buyer’s preferences are represented by:
U (q, T, θi) = θi u(q) − T
where:
• T total transfer from the buyer to the seller,
• θi preference characteristics of the buyer,
• u(q) is the buyer’s preferences for the quality of

the good, u(0) = 0, u0(q) > 0 and u00(q) < 0.
The seller is risk neutral, the unit’s cost of production

is c > 0 and her profit for selling q units of quality
in exchange of T is:
Π = T − cq
Question: what is the profit maximizing pair (T, q)

the seller will be able to induce the buyer to choose?
Assume that:
θi ∈ {θL, θH }
and
λ = Pr{θi = θL}
Let U = 0 be the buyer’s outside option.
First best: assume that the seller is perfectly in-

formed on each buyer’s type θi.
The contract is then (Ti, qi), for i ∈ {L, H}

The seller’s problem is:
max Ti − c qi
Ti ,qi
s.t. θi u(qi) − Ti ≥ 0
The constraint is the individual rationality (IR)

constraint of the agent.
The solution is such that:
θi u0(qi∗) = c, ∀i ∈ {L, H}
and
Ti∗ = θi u(qi∗), ∀i ∈ {L, H}
The seller maximizes total surplus by:
• choosing a quantity qi∗ such that marginal utility

is equal to marginal cost (efficiency),
• extracting the consumer’s total willingness to pay

by means of the transfer Ti∗.
The seller’s total expected profit:
λ (TL∗ − c qL∗ ) + (1 − λ) (TH∗ − c qH

∗
)
If the seller cannot observe the the buyer’s type then

she has to offer the same contract to both types.
In other words the seller may offer to the agent (what-

ever his type) a set of choices
(T (q), q)
In principle the contract space is potentially large:

the set of functions T (q), of all shapes and features.
Fortunately we can appeal to the Revelation Prin-

ciple to simplify the search for the best contract.
Revelation Principle: There is no loss in generality

in restricting attention to direct revelation mech-
anisms.
The direct mechanism is an alternative environment

where the principal asks the agent to report his pri-
vate information
θ̂i ∈ {θL, θH }
The principal chooses this the direct mechanism so

that it maximizes the principal’s expected profits
and it is optimal for the agent to report the truth.
The revelation principle tells us that there is no need

to look for other mechanism the one you derive is the
best among all.
The principal’s problem can be structured in 5 steps.
Step 1: Using the revelation principle the principal’s

problem is to identify the best direct mechanism:
max λ (TL − c qL) + (1 − λ)(TH − c qH )

Ti ,qi
s.t. θH u(qH ) − TH ≥ θH u(qL) − TL
θL u(qL) − TL ≥ θL u(qH ) − TH
θH u(qH ) − TH ≥ 0
θL u(qL) − TL ≥ 0
Where (Ti, qi) = (T (q(θ̂i)), q(θ̂i)), i ∈ {L, H} is the

contract associated with the direct revelation game.
An incentive compatibility constraint (IC) and an

individual rationality constraint (IR) for every θi.
Step 2: The individual rationality constraint of the

type H will not bind at the optimum.
Since θH > θL:
θH u(qH )−TH ≥ θH u(qL)−TL > θL u(qL)−TL ≥ 0
Step 3: We solve the relaxed problem that ignores

the (ICL) constraint.
To select which constraint to omit consider the two

(IC) constraints at the first best optimum.
Indeed:
∗
θH u(qH ) − TH∗ = 0
and
θH u(qL∗ ) − TL∗ = (θH − θL) u(qL∗ ) > 0
.
While
θL u(qL∗ ) − TL∗ = 0
and
∗
θL u(qH ) − TH∗ = (θL − θH ) u(qH
∗
)<0
Therefore the key (IC) constraint is the one of the

H-type.
The reason why the (IC) constraint of only one type

of agent binds is Spence-Mirrlees Single Crossing
Condition:

∂ ∂U/∂q
− = u0(q) > 0
∂θ ∂U/∂T
That is: the marginal utility of consumption (relative

to the marginal utility of money) rises with θ.
Step 4: Notice that the relaxed problem is such that

both constraints bind at the optimum:
max λ (TL − c qL) + (1 − λ)(TH − c qH )

Ti ,qi
s.t. θH u(qH ) − TH ≥ θH u(qL) − TL
θL u(qL) − TL ≥ 0
If (ICH ) does not bind then the principal can raise TH

without affecting (IRL), while improving the maxi-
mand.
The maximand is monotonic decreasing in TL while

(IRL) is monotonic increasing in TL.
Step 5: Eliminate TL and TH from the binding con-

straints and substitute them into the maximand. We
get:
max λ [θL u(qL) − c qL] +

qi
+ (1 − λ) [θH u(qH ) − (θH − θL) u(qL) − c qH ]
The second best contract (qi∗∗, Ti∗∗) is then such that:
∗∗ ∗
• efficiency at the top: qH = qH
θH u0(qH
∗∗
)=c
• inefficiency at the bottom: qL∗∗ < qL∗

−1
0 ∗∗ 1 − λ θH − θL
θLu (qL ) = c 1 − >c
λ θL
• inefficient premium to the top type: TH∗∗ < TH∗
TH∗∗ = θH u(qH
∗∗
) − (θH − θL) u(qL∗∗)
• efficient transfer to the bottom type: TL∗∗ = TL∗
TL∗∗ = θL u(qL∗∗)
Notice that from the first two conditions we obtain
qL∗∗ < qH
∗∗
We therefore obtain that the (ICL) constraint is sat-

isfied
θL u(qL∗∗) − TL∗∗ ≥ θL u(qH

∗∗
) − TH∗∗
from θH > θL and

∗∗
θH [u(qH ) − u(qL∗∗)] = TH∗∗ − TL∗∗
The result obtained can be re-interpreted in terms of

the taxation principle.
The principal offers a menu of (two) two-part tariff

contracts:
∗∗
{(qH , TH∗∗), (qL∗∗, TL∗∗)}
These contracts are such that:
• the L-type agent self-selects in choosing the con-

tract (qL∗∗, TL∗∗),
• the H-type agent self-selects in choosing the con-

∗∗
tract (qH , TH∗∗).
Notice that this re-interpretation corresponds to a

realistic indirect mechanism.

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Leonardo Felli 3 December, 2001

Advanced Economic Analysis Lecture 2

Consider now a moral hazard problem involving a

Recall that the index of absolute risk aversion is

Let the outcome y be such that

The cost of effort is quadratic:

Restrict now the principal to offer only linear con-

Recall also that if

First best contract is the solution to the following

We can then rewrite the problem as:

Since the objective function is monotonic decreasing

Solving for γ we have:

The solution is then:

• transfer to the agent

• expected profit of the principal

Assume now that the agent’s effort a cannot be in-

The agent then chooses â so as to maximize her own

Second best problem is then:

Therefore the agent’s incentive problem is then:

The unique solution to this problem is then

Then the second best problem becomes:

The solution is then:

Tradeoff: between incentives (need for risk in the

If the agent becomes less risk averse, r decreases, the

The same conclusion apply if y becomes a better sig-

In both these cases the power of the optimal incentive

Static Adverse Selection problem: one principal

We consider a monopolist’s pricing model: a trans-

The seller sets the terms of the contract.

The seller does not know how much the buyer is

The buyer’s preferences are represented by:

U (q, T, θi) = θi u(q) − T

• T total transfer from the buyer to the seller,

• θi preference characteristics of the buyer,

• u(q) is the buyer’s preferences for the quality of

The seller is risk neutral, the unit’s cost of production

Question: what is the profit maximizing pair (T, q)

Let U = 0 be the buyer’s outside option.

First best: assume that the seller is perfectly in-

The contract is then (Ti, qi), for i ∈ {L, H}

The seller’s problem is:

The constraint is the individual rationality (IR)

The solution is such that:

The seller maximizes total surplus by:

• choosing a quantity qi∗ such that marginal utility

• extracting the consumer’s total willingness to pay

The seller’s total expected profit:

λ (TL∗ − c qL∗ ) + (1 − λ) (TH∗ − c qH

If the seller cannot observe the the buyer’s type then

In other words the seller may offer to the agent (what-

In principle the contract space is potentially large:

Fortunately we can appeal to the Revelation Prin-

Revelation Principle: There is no loss in generality

The direct mechanism is an alternative environment

The principal chooses this the direct mechanism so

The revelation principle tells us that there is no need

The principal’s problem can be structured in 5 steps.

Step 1: Using the revelation principle the principal’s

max λ (TL − c qL) + (1 − λ)(TH − c qH )

s.t. θH u(qH ) − TH ≥ θH u(qL) − TL

Where (Ti, qi) = (T (q(θ̂i)), q(θ̂i)), i ∈ {L, H} is the

An incentive compatibility constraint (IC) and an

Step 2: The individual rationality constraint of the