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

Moral Hazard: The Basic Trade-Offs

In chapter 2, we stressed that the delegation of tasks creates an information gap between the principal and his agent when the latter learns some piece of informa- tion relevant to determining the efficient volume of trade. Adverse selection is not the only informational problem one can imagine. Agents to whom a task has

Moral Hazard: The Model

1. Effort and Production  We consider an agent who can exert a costly effort e. Two possible values can be taken by e, which we normalize as a zero effort level and a positive effort of one: e  in  {0, 1}.  Exerting  effort  e  implies  a  disutility  for  the  agent  that  is  equal  to 

Moral Hazard: Risk Neutrality and First-Best Implementation

If the agent is risk-neutral, we can assume that (up to an affine transformation) u(t) = t for all t and h(u) = u for all u. The principal who wants to induce effort must thus choose the contract that solves the following problem: With risk neutrality the principal can, for instance, choose incentive compat-ible transfers

Moral Hazard: The Trade-Off Between Limited Liability Rent Extraction and Efficiency

Let us consider a risk-neutral agent. As we have already seen, (4.3) and (4.4) now take the following forms: and Let us also assume that the agent’s transfer must always be greater than some exogenous level −l, with l ≥ 0. The framework is quite similar to that of section 3.5, and we refer

Moral Hazard: The Trade-Off Between Insurance and Efficiency

Let us now turn to the second source of inefficiency in a moral hazard context— the agent’s risk aversion. When the agent is risk-averse, the principal’s program is written as: It is not obvious that (P) is a concave program for which the first-order Kuhn and Tucker conditions are necessary and sufficient. The reason for