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# ADVANCED MICROECONOMICS II:

INCENTIVE THEORY
Lecture 2a: Adverse Selection - Screening With Two Types

## Prof. Christian KEUSCHNIGG

University of St. Gallen, FGN-HSG
FGN-HSG

November 3, 2014

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Introduction

## Theory of incentives and information: bilateral contracting

principal wants to control decisions of agents
hidden information (adv. selection) vs. hidden action (moral hazard)

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## screening: contract proposed by uninformed party

signaling: contract proposed by informed party

## Examples: of screening problems

regulation and price discrimination, credit rationing
optimal income taxation, labor contracts

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## 1. The Economic Problem

Principal: faces agent with private information of her type
problem of non-linear pricing by a monopolistic seller
who faces a buyer with unknown valuation for her product

## Buyer: dierent types q, with linearly separable preferences

u (q, T , q ) = qv (q ) ! T
payment T to seller for quantity q of good, v 0 (q ) > 0 > v 00 (q )
preference parameter q: 2 types, high or low valuation, q H > q L
demand characteristic q is private information of buyer
seller knows only distribution b = Pr (q = q L ), 1 ! b = Pr (q = q H )

p = T !c #q

## Question: what is the best (prot maximizing) contract (T , q )

so that seller (principal) is able to induce buyer (agent) to accept?
Christian Keuschnigg (FGN-HSG)

## L2a: Screening - Two Types

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1. Preference Characteristics

## Indierence curves: equal utility (T , q )-bundles of type q i

!
dT !!
T = q i v (q ) ! u,
= q i v 0 (q ) = MRSi
dq !du =0
Single-crossing: Spence-Mirrlees condition, Figure 1

## same bundle (T , q ) ) q H -type has larger valuation MRSi

same budget line ) q H -type demands larger quantity

## Demand: given payment-schedule Ti = Pqi + F

ui = q i v (qi ) ! Ti

## L2a: Screening - Two Types

q i v 0 (qi ) = P

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## 2. First Best Allocation With Full Information

Social value: of seller-buyer relationship, Si = ui + p i or
ui = q i v (qi ) ! Ti ,

p i = Ti ! cqi ,

Si = q i v (qi ) ! cqi

## Agent: with reservation utility (outside value) u

participation (individual rationality) constraint: q i v (qi ) ! Ti % u
u reects agents bargaining power relative to principal

## Full information: seller observes buyers type, Fig. 2

seller can oer type specic contracts (Ti , qi ) for each type q i
p i = maxT i ,qi Ti ! cqi

s.t.

q i v (qi ) ! Ti % u

## substitute Ti into p i , and maxqi p i = q i v (qi ) ! cqi ! u

FB : q i v 0 (qi& ) = c,
Christian Keuschnigg (FGN-HSG)

Ti& = q i v (qi& ) ! u

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## First best: maximizes social value (total surplus) Si , Fig. 2

rst best reects perfect price discrimination
with type specic contract Ti& , qi&
marginal utility (price) equals marginal cost
principal gets full surplus, no rent to buyer, ui = u

## Implementation: type specic 2 part tari Ti = cqi + p i

charge price c and xed fee p i to extract rent, i.e.
ui = q i v (qi ) ! Ti = u

## First best: optimal contract maximizes total surplus Si

participation constraint determines how total surplus is shared

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## 3. Hidden Information - Simple Solutions

Asymmetric information: seller cant observe types
oer same contracts fT (qi ) , qi g to everybody, consider now:
(i) linear pricing, (ii) two part tari, (iii) non-linear pricing

## Linear pricing: contract species only price p, i.e. T (q ) = pq

given p, buyer i chooses quantity qi to maximize surplus (utility)
Si = maxq q i v (q ) ! pq
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f.o.c. yields demand functions, Di0 (p ) = 1/ q i vi00 < 0
q i v 0 (qi ) = p

qi = Di (p )

## and buyer i gets a maximum surplus (utility)

Si (p ) = q i v (Di (p )) ! pDi (p )

## Expected demand/surplus: sum up over types

D ( p ) = b # DL ( p ) + ( 1 ! b ) # DH ( p ) ,
S ( p ) = b # SL ( p ) + ( 1 ! b ) # SH ( p )

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## 3. Hidden Information - Simple Solutions

Linear pricing: set prot maximizing monopoly price p
p = maxp (p ! c ) # D (p )
f.o.c. implies mark-up pricing (note D 0 < 0)
D + (p ! c ) D 0 = 0

pm = c +

D (p )
>c
!D 0 (p )

## Linear pricing: Figure 3, monopoly price implies

ineciently low consumption since q i v 0 (qi ) = p > c,
max. prot by restricting demand and raising p above unit cost
buyersR are left with rent (area Runder demand Rcurve) Si (p ) > 0,
q
q
q
Si = 0 p (x ) dx ! pq, where 0 i p (x ) dx = 0 i q i v 0 (x ) dx = q i v (qi )

## Question: can seller do better and extract part of buyers rent?

Christian Keuschnigg (FGN-HSG)

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## Figure 3: Linear Monopoly Pricing

Optimality: q + (p ! c ) dq
dp = 0

## Christian Keuschnigg (FGN-HSG)

p + q dp
dq = c or MR = MC

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## 3. Hidden Information - Simple Solutions

Two part tari: no explicit discrimination
payment schedule: price p and xed fee Z , same for both types
T (q ) = pq + Z
utility ui = maxq q i v (q ) ! (pq + Z ) = Si (p ) ! Z
by envelope theorem, Si (p ) = q i v (q ) ! pq yields Si0 (p ) = !Di (p )

## Participation: rm wants to serve both types

can extract maximum fee Z * SL (p ) such that uL % 0

## Prot: max. p = T ! cq with T = pD (p ) + SL (p ), i.e. Z = SL (p )

p = maxp (p ! c ) D (p ) + SL (p )
f.o.c. D (p ) + (p ! c ) D 0 (p ) + SL0 (p ) = 0, implying mark-up
p=c+

D (p ) + SL0 (p )
>c
!D 0 (p )

## note D + SL0 = bDL + (1 ! b) DH ! DL = (1 ! b) (DH ! DL ) > 0

Christian Keuschnigg (FGN-HSG)

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## 3. Hidden Information - Simple Solutions

Compare prices: p m > p d > p c = c
monopoly > 2-part > rst best competitive price
small price reduction starting from monopoly price p m
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## 2nd order negative eect on prot (p m ! c ) D (p m ),

due to envelope theorem, p m maximizes monopoly prot
1st order positive eect of lower price on surplus (SL0 = !DL ),
seller can extract this gain by raising the xed fee Z

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## 1st order positive eect on prot (p c ! c ) D (p c ),

2nd order negative eect on surplus SL ,
envelope theorem, competitive price p c maximizes surplus

## rst best not optimal for monopolist,

mark-up p d > c leads to underconsumption

## Compare prots: p d > p m > 0, 2-part contract more protable

xed fee Z extracts more surplus from buyers (uL = 0, uH lower)
Christian Keuschnigg (FGN-HSG)

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## Figure 4: Optimal Two Part Tari

Remark: q H -type strictly prefers allocation BH to BL ,
seller could extract even more rents, i.e. from q H -type

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## 4. Second Best - Optimal Nonlinear Pricing

Idea: rm can do better than with a 2-part tari
Non-linear contracts: rm cannot observe buyers type
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## oer set of choices [q, T (q )] independent of type

given T (q ), buyer picks outcome yielding highest pay-o

## Program: anticipating buyers choices, seller maximizes

p = max b [T (qL ) ! cqL ] + (1 ! b) [T (qH ) ! cqH ]
T (q )

ICi

qi = arg max q i v (q ) ! T (q )

IRi

ui = q i v (qi ) ! T (qi ) % 0

s.t.

for i = L, H,

for i = L, H.

## IC incentive compatibility constraints

IR individual rationality (participation) constraints

## Diculty: rm must choose among alternative functions T (q )

solve with a 5 step procedure
Christian Keuschnigg (FGN-HSG)

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## 4. Second Best - Optimal Nonlinear Pricing

STEP 1: apply revelation principle (see Mathematical Toolkit)
one may restrict large set of schedules T (q ) to pair of choices
[qi , T (qi )] made by each type of buyer, use notation Ti = T (qi )
need only as many options as there are dierent types

## Program: anticipating buyers choices, seller maximizes

p = maxT i ,qi b [TL ! cqL ] + (1 ! b) [TH ! cqH ]

ICH

ICL

IRH

IRL

s.t.

q H v (qH ) ! TH % q H v (qL ) ! TL ,

q L v (qL ) ! TL % q L v (qH ) ! TH ,

uH = q H v (qH ) ! TH % 0,
uL = q L v (qL ) ! TL % 0.

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ICi : q i -type must prefer own contract (qi , Ti ) over other qj , Tj
IRi : each type must be willing to accept and participate

## Revelation principle: oers great simplication

reduce choice over innitely many functions T (q ) to two options
Christian Keuschnigg (FGN-HSG)

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## 4. Second Best - Optimal Nonlinear Pricing

STEP 2: eliminate IRH , not binding in FB, also not in 2nd best
q H v (qH ) ! TH % q H v (qL ) ! TL % q L v (qL ) ! TL % 0
1st inequality from ICH , 2nd from q H > q L , last from IRL

## STEP 3: eliminate ICL which is not binding in rst-best

and check that it is also not binding with 2nd best solution

## 1st best: ecient demand q i v 0 (qi& ) = c, no rent q i v (qi& ) = Ti& ,

ICH is violated in FB (1st best) with full rent extraction
&
q H v (qL& ) ! TL& = (q H ! q L ) v (qL& ) > 0 = q H v (qH
) ! TH&

## ICL is slack in FB with full rent extraction

&
q L v (qH
) ! TH& = ! (q H ! q L ) v (qH& ) < 0 = q L v (qL& ) ! TL&

## Result: eliminate ICL , slack in 1st best, check in 2nd best

Fig.1: single crossing, high valuation q H , want large quantity qH ,
low valuation q L , want small quantity qL , uL falls if qL ! qH .
Christian Keuschnigg (FGN-HSG)

November 3, 2014

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## 4. Second Best - Optimal Nonlinear Pricing

STEP 4: remaining constraints ICH , IRL binding in reduced problem
p = maxT i ,qi b [TL ! cqL ] + (1 ! b) [TH ! cqH ]

ICH

IRL

s.t.

q H v (qH ) ! TH % q H v (qL ) ! TL ,

uL = q L v (qL ) ! TL % 0.

## ICH binding, otherwise raise TH without eect on IRL

IRL binding, otherwise raise TL , but this
tightens omitted ICL , thus check in the end!

## STEP 5: substitute Ti from binding ICH , IRL constraints

max b [q L v (qL ) ! cqL ] + (1 ! b) [q H v (qH ) ! cqH ! (q H ! q L ) v (qL )]
qi

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## seller gets full rent from q L -type since IRL binding,

but must leave informational rent (q H ! q L ) v (qL ) to q H -type,
informational rent increases with consumption qL of q L -type

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## 4. Second Best - Optimal Nonlinear Pricing

Non-linear pricing: 2nd best optimal contracts qjo , Tjo fulll f.o.c.
q H v 0 (qHo ) = c,

q L v 0 (qLo ) =

c
> c,
m

m , 1!

1 ! b qH ! qL
<1
b
qL

## if m < 0, then d p/dqL = b [m # q L v 0 (qL ) ! c ] < 0, implying qLo = 0,

i.e. the rm would optimally want to exclude q L -type buyer
o > qo
larger demand of buyer with high valuation, qH
L

## CHECK suppressed constraints: IRH and ICL satised?

" o#
o
1 show IR
H is slack, i.e. q H v qH ! TH > 0:
proof: ICH and IRL binding and q H > q L imply
IC

q H >q L

IR

o
q H v (qH
) ! THo =H q H v (qLo ) ! TLo > q L v (qLo ) ! TLo =L 0
" #
" o#
show ICL is slack, i.e. q L v % q"Lo !# TLo %
q L#&
v qH
! THo
"
o
o
o
o
proof: use TH = TL + q H v qH ! v qL from%binding
" o # ICH ," o #&
and nd that ICL is equivalent to 0 % ! (q H ! q L ) v qH
! v qL

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## 4. Second Best - Optimal Nonlinear Pricing

Non-linear pricing: f.o.c. for 2nd best optimal contracts
q H v 0 (qHo ) = c,

q L v 0 (qLo ) =

c
> c,
m

m<1

o > qo
larger demand of buyer with high valuation, qH
L

## Economic conclusions: illustration Figure 5

1

o = q& ,
no distortion at top: demand of q H -type is rst best, qH
H
o
&
but consumption of q L -type is ineciently low, qL <
" qoL#
q H -type gets positive information rent (q H ! q L ) v qL ,
q L -type gets a surplus/rent of zero (IRH is slack, IRL is binding)!
information rent depends on demand qLo of low-type,
reducing allocation qLo relaxes ICH constraint, i.e.
makes mimicking by high type less attractive,
seller thereby reduces information rent and extracts even more

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## Figure 5: From 2-Part to 2nd Best Solution

High type: IC binding, IR slack; Low type: IC slack, IR binding

## L2a: Screening - Two Types

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Summary
Main insights: when agent has private information
principal: gets larger pay-o by clever design of contract menu
revelation principle: need no more than one contract per type

## Basic results: 1st best, principal can extract all surplus

2nd best, can extract only part of agents surplus
must leave information rent to prevent adverse selection,
i.e. information rent necessary to satisfy incentive compatibility
eciency at the top, but inecient allocation for lower types

## Preview: next lectures

this lecture: L2a - screening with two types
next lecture L2b - screening with many types (continuously many)
Lecture L3 - applications of screening: there are many!
optimal income taxation, capital markets, regulation
social insurance, labor contracts, workfare etc.

## Literature: Lectures 2a-b based on

Bolton and Dewatripont (2005), chapter 2, without subsecs 2.3.1-2
parts of Laont/Martimort (2002, ch. 2) and Salanie (1999, ch.2)
Christian Keuschnigg (FGN-HSG)

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