Asymetries of Information: Moral Hazard and Adverse Selectiona

Asymmetries of Information:
Moral Hazard and Adverse Selection

Daniel Hojman
This version: July 24, 2013
In many markets and economic relationships -perhaps most- the parties involved in a transaction or the signing of a contract do not have equal access to information directly relevant
to the exchange. For example, when we buy a computer, it is hard to know in advance if the
processor is fast and reliable. The computer producer or the seller are likely to know much
more about the quality of their product. This happens with all experience goods, such
as a car or a movie. Learning about the quality of the good happens after purchasing and
experiencing consumption. In these cases, the supplier has better information than potential
buyers. On the hand, when an individual demands health insurance, the information she has
about his or her own health history, family factors, and habits is much better than the one a
potential insurer may have. In this case the demand side has private information relevant to
the supplier. Regardless of who holds the private information, in all of these examples, the
asymmetry of information is associated with a characteristic or quality of the good. There is a
hidden characteristic.
Sometimes asymmetries of information are associated with behaviors difficult to observe
rather than unobserved characteristics. For example, unless an employer has access to a perfectmonitoring system -which could be ethically or legally questionable- it might be difficult to
determine if an employee is doing a good job. The sales of a shop are affected by a number of
variables: the efforts of employees and other factor beyond their control such as the location of
the shop, the weather or the state of the economy. If sales are low, it could be due to a poor
effort but also to external factors that lead to a low demand. There are many examples of
this nature. It can be difficult to tell if a manager is carrying out a strategy that benefits the
shareholders of a company or one that may involve a short-term private benefit to the manager
or benefit friends. In politics, it can be hard to assess if a public official allocates resources
appropriately -in ways the public he or she is supposed to represent might support- as opposed
to sustaining a patronage network or corruption. In all of these examples, the asymmetry of
information is associated with a hidden action.
In general, information asymmetries may lead to efficiency losses, market and government
failures. In this chapter we consider two phenomena that can arise with asymmetric information: the moral hazard and adverse selection. Moral hazard concerns information asymmetries
related to behavior. If actions cannot credibly be contracted upon and their is conflict of interest, the risk of opportunistic behavior by one of parties after signing a contract may lead
to inefficient outcomes. If characteristics of a good are unobserved before signing a contract,
this may lead to lower trade -rationing or no trade whatsoever. With hidden characteristics,
self-selection is likely to determine the quality of the goods that end up being exchanged.
The tools developed here should be useful to analyze a wide range of economic and social
phenomena. Information asymmetries play a central role in organizing labor markets, financial
markets, insurance, experience goods, health and education, within organizations, the government, or even the family.
Chapter 1
Moral Hazard and the

Principal-Agent Model
The term moral hazard was used in British insurance markets in the late nineteenth century. The idea was that someone who buys insurance may engage in opportunistic or reckless
behaviors precisely because he or she is insured.
To illustrate this point, suppose that if someone parks a car on the street there is a 10%
chance of it being stolen. This could motivate someone to buy insurance. The moral hazard
problem is that once the individual has insurance, he might be less careful when closing the
car or choosing a safe place to park. Moral hazard occurs because the insured can affect the
probability of the event that triggers the insurance payment. The problem arises from the
inability of an insurer to verify the behavior of the insured. If reckless behavior were observed
and most importantly, if these actions were verifiable by a court of law, one could write contracts
that specify a coverage level contingent on the behavior: If you make an effort to reduce poor
performance, coverage insurance is $1,000, if reckless, their coverage is $0.
How can insurance companies deal with the potential of moral hazard? A common response
is the use of deductibles and co-payments. These instruments aim to induce the insured to actions that reduce the incidence of a bad outcome. By assuming part of the risk, the individuals
incentives are more more aligned with those of the insurance company. However, this happens
at a cost: lower insurance. Further, the individual may be totally alien to the occurrence of
an accident or theft, he could be extremely careful but must settle for a lower coverage, as this
behavior cannot be verified by the insurer. In general, moral hazard leads to higher insurance
premiums and lower coverage than would be efficient.
Beyond this classic example, there are many economic and social situations in which moral
hazard can play a central role and lead to inefficiencies or contracts carefully designed to minimize the incentive problems associated with the potential of opportunistic behavior. An
important family of cases are agency problems. Agency problems arise when a principal delegates a task to another person, the agent. For example, in a company the shareholders delegate
Harvard Kennedy School - FEN, Universidad de Chile
the management-management-agents to make decisions affecting the destiny of the company.

The principal-agent problem arises if the goal of the agent differs from that of the principal,
the agent can have a significant impact on the well-being of the principal and information
asymmetries make it hard to verify if the actions taken by the agent are those that the principal
would choose to maximize her utility. In sum, moral hazard can arise when there is a conflict
of interest and information asymmetries hinder the possibility of verifying an opportunistic
behavior.
We analyze a model that is helpful in a wide range of moral hazard problems, the PrincipalAgent model. We explore the impact that different contracts may have in aligning the objectives
of the agent to the interest of the principal. At the end of the chapter, we then discuss a number
of real-world examples, including applications to microfinance, social policy and politics.
1.1
The Principal-Agent Model
The core elements of the Principal-Agent problem can be illustrated with a basic model:
There is a principal who delegates a task to an agent. The task is functional to the
principals objectives (e.g. sales, private value, public value).
The agents action affects the outcome of this task (e.g effort, choice of a project).
The action is not observable by the principal. More importantly, even if it were observable, the action is not verifiable by a court of law. This means that the compensation
contract offered by the principal, cannot explicitly specify the action to be performed by
the agent. (Even if the contract specified what the agent should do, it would be dead
law.) The contract can only be contingent on results that are observable and verifiable
ex-post. For example, the effort of a seller may not be observable but sales are. If there
is a statistical relationship between effort and sales, one way to align incentives might be
to make the compensation contract contingent on sales.
The principal offers a contract that the agent can accept or reject. The principal cannot
force the agent to accept the contract. To induce the agent to accept a contract, the principal must offer a contract that gives the agent at least the same utility as her outside
option (e.g. an alternative job or home production).
If the agent accepts the contract, he chooses what action to take.
We formalize the above description using a model. To fix ideas, suppose that the principal,
Paula, owns a car dealership. The agent, Andrew, is a potential seller. Sales are a random
variable x
that depend on agents effort and other exogenous factors that are not controlled by
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either the principal or the agent such as the macroeconomy or the weather. For simplicity, we
assume that there are two levels of sales A and B, with A > B.
In this model, a contract is a compensation scheme contingent on observable sales x
{A, B}.
That is, a contract specifies compensation for each level of sales. Given our assumption of two
levels of sales, a contract is a pair (wA , wB ), where wA is the compensation if sales are high
and wB is compensation if sales are low.1
After observing the offer, the agent can accept it or reject it. If the offer is rejected, we assume that the agent prefers an outside option and gets a reservation utility u0 . If the agent
accepts the contract, the agent chooses the level of effort e {eL , eH }, where eH is the high
level of effort and eL . This effort affects the probability of successful sales. Let P r(
x|e)
be the probability of a sales level x
given the agent chooses a level of effort e. Note that
P r(
x = A|e) + P r(
x = B|e) = 1.
The following table describes the statistical relationship between sales -observed outcomeand effort -unobserved action.
Effort (e)
eH
eL
P r(
x = A|e)
pH
pL
P r(
x = B|e)
1 pH
1 pL
Naturally pH > pL . That is, high sales are more likely if effort is high than if it is low.
We complete the description of the model by specifying the utility functions of the principal
and the agent. We assume that the principal is risk neutral and she only cares about her net
x, w)
profit, so that her utility is (
=x
w.
If the agents effort level is e, the expected utility
for the principal is
(e, wA , wB ) = P r(
x = A|e)(A wA ) + (1 P r(
x = A|e))(B wB ).
For example, if e = eH ,
(eH , wA , wB ) = pH (A wA ) + (1 pH )(B wB ).
We assume that the agent is risk averse and maximizes his expected utility. The Bernoulli
utility of the agent is
U (w,
e) = v(w)
C(e),
where v() is an increasing and concave function and C(e) is the cost of effort. Without further
loss of generality, we normalize C(eL ) =0 and define CH = C(eH ) > 0. The expected utility of
the agent as a function of the contract (wA , wB ) is given by
1
If there were three levels of sales, A, B and C, a contract would be a triplet (wA , wB , wC ).
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V (e, wA , wB ) = E[U (w,

e)|e] = P r(
x = A|e)v(wA ) + (1 P r(
x = A|e))v(wB ) C(e).
Note that
V (eH , wA , wB ) = pH v(wA ) + (1 pH )v(wB ) CH
and
V (eL , wA , wB ) = pL v(wA ) + (1 pL )v(wB ).
The extensive form of the sequential game that describes the relationship between the agent
and principal is illustrated. The subgame perfect equilibrium of this game can be found using
backwards induction. Note that, conditional on optimal reactions of the agent, the principal
can determine the equilibrium in the subgame in which the agent moves.
[Insert figure game extensively]
This situation can be formulated as an optimization problem in which the principal chooses a
contract and the effort level to be implemented constrained by the fact that the agent chooses
optimally whether to accept or reject the contract and, if he accepts, he decides the level of
effort.
In formal terms, the equilibrium of the game corresponds to the solution of a constrained optimization problem: the principal maximizes her expected utility choosing a contract (wA , wB )
and implementing a level of effort e subject to two constraints: a participation constraint (P )
that indicates that the agent prefers to accept the contract and an incentive compatibility constraint (IC) that indicates that if the agent accepts the contract, the agent prefers the level of
effort that the principal aims to implement. The constraints express the fact that the principal
can not force the agent to accept the contract and does not directly choose the effort level. The
problem is then:
max
(e,wA ,wB )
(e, wA , wB )
subject to
V (e, wA , wB ) u0
V (e, wA , wB ) V (e0 , wA , wB ), e0 6= e.
The optimal contract can be found in two steps:
(e), w (e)) that minimizes the ex1. First, for each level of effort e, find the contract (wA
B
pected value of the compensation subject to the participation (P) and the incentive
compatibility (IC) constraints. That is, for each e = eL , eH , solve
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min P r(
x = A|e)wA + (1 P r(
x = A|e))wB
(wA ,wB )
subject to
V (e, wA , wB ) u0
V (e, wA , wB ) V (e0 , wA , wB ), e0 6= e.
2. Second, using the solution of previous step, find the effort level e that maximizes the
(e ), w (e )) with
utility of the principal. That is, compare L = (eL , wA
L
H =
B L
(eH , wA (eH ), wB (eH )).

Before finding the general solution to this problem, we develop an example that illustrates
the economic intuition of the problem.
1.1.1
Example: The trade-off between incentives and insurance
In this example we assume that A = 1, 800 and B = 0. The probability of selling A if the
effort is low is pL = 0 and, if the effort is high, pH = 0.6. Andrews Bernoulli utility function
is v(w) = w, CH = 9 and that the outside option is associated with a reservation utility of
u0 = 10.
We analyze the incentives associated to different compensation schemes. In principle, a contract
must achieve two objectives. On the one hand, provide incentives for the agent to do what is
good for the principal, achieve the task or exert high effort. On the other, it must make the
deal attractive enough for the agent relative to her/his outside option. These objectives can be
at odds as we aim to illustrate. The principal faces a trade-off between exposing the agent to
risk to encourage a high effort level and insuring the agent to reduce the high premium required
to compensate the agent for taking a risk. As a benchmark, we start with the first best (FB)
case in which there are no information asymmetries.
First Best: Observable effort

Assume that Paula observes the effort made by Andrew. Moreover, effort can be verified by a
court of law, which implies that a contract contingent on Andrews actions can be enforced. If
Paula wanted to implement eH she can offer the following contract: If you shirk (e = eL ) I
will sue you, you will go to prison for a long time and I will also destroy your reputation. If
you try (e = eH ) gain $400 regardless of whether you sell or not. The punishment is so strong
that we can be sure that Andrew would strive if he accepts the contract. Thus, if the effort is
observable, incentive compatibility is not an issue.
Would Andrew accept the contract? The participation constraint (P) is satisfied if and only if
Andrews utility of accepting the contract, U (w = 400, eH ) is at least
as large as u0 the utility
of the outside option. Noting that U (w = 400, eH ) = v(400) CH = 400 9 = 11 > 10, we
Imperfect Markets
see that the constraint is satisfied with slack. In short, Andrew would take the contract and
would choose eH .
Is this contract is optimal for the principal? As long as (P) is satisfied, the principal can reduce
the compensation and increase her expected utility. Indeed, the optimal wage level corresponds
to w0 such that v(w0 ) CH = u0 or w0 = 19 w0 = 361. The expected utility of the principal

is E[] = 0.6 1, 800 361 = $719.
We can therefore conclude that if effort is observable, the optimal contract is independent
of sales. Hence, Andrew is completely insured.
Second Best: asymmetric information, non-observable effort

We return to the case in which effort is not observable and therefore it is not possible to enforce
a contract contingent on it.
We consider three compensation schemes:
1. Flat salary:
Paula offers a salary of 400 independent sales, so that the agent faces no risk. We analyze
the two constraints, (IC) and (P). If Andrew accepts the contract will he choose eH ?
Would Andrew accept the contract?
We start with the (IC). Andrew chooses eH if and only if V (w = 400, e = eH ) V (w =
400, e = eL ). This does not hold as v(400) CH v(400), the (IC) is violated: if Andrew
accepted the contract, he would choose eL .
Observe that the participation constraint is satisfied. If Andrew takes the contract his
payoff would be V (w = 400, e = eL = 20) which exceeds u0 = 10.
In general, with asymmetric information and risk-free wage scheme, the agent will have
no incentive to strive.2
2. Sales contract
Suppose that Paula offers a contract fully contingent on sales: sales are shared equally.
That is, w
=x
/2, or equivalently, wA = 900 and wB = 0.
Under this scheme the wage is a random variable. The distribution depends on the effort
level chosen. In particular, if e = eL , w|
eL = wB = 0. If instead e = eH ,

w|
e=eH =
wA = 900 with probability 0.6

wB = 0 with probability 0.4
In this section we consider intrinsic motivation, a central aspect of human motivations. The focus is on
material incentives.
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In contrast to the flat compensation scheme, if Andrew took the job, he would
choose
eH . In this case, the expected utility associated to e
900, 0) = 0.6 900 + 0.4
H is V (eH ,
0 9 = 9. The utility of eL is V (eL , 900, 0) = 0 900 + 1 0 = 0. Thus, the (IC) is
satisfied as 9 0.
However, the contract does not satisfy (P) as V (eH , 900, 0) = 9 u0 = 10. We conclude
that under this scheme Andrew prefers the outside option.
The scheme incentivizes Andrew to exert effort for effort and is associated with an expected compensation of $540 (= 0.6$900), relatively high compared to $361, the compensation required to implement eH with complete information. Clearly, if Andrew received
the expected salary for sure he would accept the contract. The problem is that Andrew is
risk averse and this scheme is associated with a high volatility (the standard deviation of
the compensation is = 441). In order for the agent to accept the job, the principal must
compensate the agent with a high enough risk premium. In this case, it would require a
higher share of sales.
3. An intermediate scheme: Base + Bonus
Suppose now that Paula offers Andrew a contract with an intermediate wage scheme,
one that ensures him a certain amount but also exposes him to risk by offering a bonus
contingent on sales. The contract has a fixed component of $150 -the base- and a variable component -a bonus- equal to 1/3 of the profits
from sales.
That is, wA = $150 and

wB = $750. We seethat V (eH , 750, 150) = 0.6 750 + 0.4 150 9 = 12.33. Moreover,
V (eL , 750, 150) = 150 = 12.24. Thus, under this scheme, the expected utility associated
to the high effort level s greater than the expected utility of low effort level, the (IC) is
satisfied. (P) is also fulfilled as 12.33 10. This contract induces Andrew to accept and
choose eH .
Note that in this case the expected compensation is $510 (= 0.6 750 + 0.4150) and its
standard deviation is = 294. Comparing this scheme with the sales contract, we see
that in this case the expected cost of implementing high effort is lower, implying a greater
surplus for Paula (further, in the previous case (P) was not even satisfied). Reducing the
risk faced by Andrew not only makes the contract more attractive relative to the outside option but it lowers cost of implementing high effort. The intuition is that the risk
premium paid by the principal get the risk averse agent to accept the contract is smaller
because the risk is lower.
The example illustrates that with asymmetric information, exposing the agent to risk is necessary to encourage their effort. Unlike the case where effort is observable, the (IC) constraint
to implement eH requires not to fully insure the agent. On the other, the higher the risk
faced by the agent (who is risk averse), the higher the risk premium the principal must pay to
make the contract attractive relative to the outside option. That is, increasing risk, implies a
higher expected compensation required to ensure that (P) is satisfied, increasing the cost for
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the principal. Consequently, the optimal contract balance the trade-off between exposing the
agent to risk to incentivize high effort and insuring the agent to reduce risk premium required
to make the agent participate.
1.2
The optimal contract
We characterize the optimal contract for the general case. As before, we start with the case in
which effort is observable.
1.2.1
First Best: Observable effort
If effort is observable and verifiable by a court then the (IC) constraint is irrelevant as the
contract can specify the level of effort. The optimal contract only considers the participation
constraint (P). In this case the principal can implement an effort level e that will give her the
highest profit by paying the lowest wage consistent with (P). This means that, at the optimal
contract, (P) binds (it holds with equality).
Then, to implement eL , the optimal wage is w0 = v 1 (u0 ). In the above example, we have
that w0 =100. To implement eH optimal salary is wH = v 1 (u0 + CH ). In the example, this
number is wH = $361.
Using these values, implementing eL yields the principal a payoff of
L = pL A + (1 pL ) B v 1 (u0 ).
Implementing eH is associated with a utility for the principal of
H = pH A + (1 pH ) B v 1 (u0 + CH ).
In our example, L =-100 and H =719, from which it follows that it is optimal for the
principal to implement eH .
1.2.2
Second Best: Asymmetric information, non-observable effort
We start by finding the contracts that minimize the cost of implementing each level of effort.
Note that to implement the low effort level, eL , the principal faces no incentives/insurance
trade-off as she does not need to provide incentives to exert effort. Consequently it is optimal
to offer a contract that fully insures the agent. As in the case of observable effort, the optimal
compensation is the smallest one satisfying (P). That is, the optimal contract to implement eL
(e ) = w (e ) = w , identical to the case of observable effort. The utility of the principal
is wA
0
L
B L
is also the same, L = pL A + (1 pL ) B v 1 (u0 ).
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10
The optimal contract that implements eH solves

min pH wA + (1 pH ) wB
(wA ,wB )
subject to
pH v(wA ) + (1 pH ) v(wH ) CH u0
pH v(wA ) + (1 pH ) v(wH ) CH pL v(wA ) + (1 pL ) v(wH ).
This is an optimization problem with two variables and two constraints.
Proposition 1. In optimal problem of minimizing the cost of implementing eH , both constraints, participation (P) and incentive compatibility (IC), bind.
The proof is the Appendix. The figure illustrates the feasible region associated with both
constraints, (P) and (IC). The equation pH v(wA ) + (1 pH ) v(wH ) CH = u0 defines an
indifference curve in the plane (wA , wB ). All pairs above this curve are contracts that satisfy
(P). Meanwhile, the corresponding equation (IC) defines another curve. To gain some intuition,
we rewrite (IC):
p (v(wA ) v(wB )) CH ,
where p = pH pL . Hence, the (IC) says that a bonus -a spread between the high and low
sales compensation levels- is required to induce high effort. The 45 degree line corresponds to
equal wages or full insurance. The increasing curve above this line represents this minimum
spread consistent with the (IC). Any contract above this curve satisfies the (IC). Finally, the
objective function of the problem is linear and the iso-cost curves are straight lines of the form
H)
wA = (1p
wB + . Lower implementation costs correspond to iso-cost lines closer to the
pH
origin. The optimal contract is the pair where corresponding to the intersection of curves where
each of constraints bind.
Since both constraints bind at the optimum, the optimal contract can be solved using the two
equations defined by binding constraints. There are two equations and two unknowns. Solving
, w ), such that
these equations, the optimal contract to implement eH is (wA
B
v(wB
) = u0 + CH
pH
CH
p
and
v(wA
) = u0 + CH +
1 pH
CH .
p
We can return to our sales example and use the above equations for the optimal contract that
= $625 and w = $100. That is, the optimal contract is
implements eH . We find that wA
B
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11
Figure 1.1: Optimal Contract

not flat and exposes the agent to the risk necessary to implement high effort. The agents
equilibrium utility is still u0 . However, the expected compensation is $415 which is greater
than $361, the compensation required to implement eH when effort is observable. The utility
of principal is then H = $665, which is lower than the utility for the principal when effort is
observable (719). The welfare loss for the principal, the agency cost, is precisely the difference
in the cost of compensation, namely, $54 (=719-665=415-361).
The optimal effort level

Having determined the optimal contracts to implement each effort level, the optimal effort level
is characterized. Using the previous results, implementing eL reports a profit L = pL A+(1
)+(1p )(B w ).
pL )B v 1 (u0 ) while implementing eH reports a profit H = pH (AwA
H
B
The level of effort to implement is determined by comparing L with H . Considering x =
A B, we have that
H L = p x [pH wA
+ (1 pH )wB
v 1 (u0 )]
If H L 0, then it is optimal for the principal to implement eH , while if H L 0,

eL is optimal. In our example, H = 665 > L = 100, where eH is the optimal effort.
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1.3
12
Welfare Analysis
In this model, the utility of the agent in any optimal contract is always the same: the participation constraint (P) always binds which means that the agent obtains an expected utility
of u0 in any scenario. Either in the first best or with asymmetric information, regardless of
whether it is optimal to implement eL or eH , the principal fully extracts the agents surplus3
Accordingly, welfare analysis can focus on the utility of the principal.
We saw that if it is optimal to implement to low level of effort, eL , the optimal compensation
is the same in the first best (FB) and the second best (SB). In contrast, if the optimal effort
is eH , (SB) requires a compensation whose expected value is greater than that of the first best
(FB). Hence:
If it is optimal to implement eL in the (FB) situation, it is also optimal in (SB). The
implementation cost is the same in both cases.
If it is optimal to implement eH in the (FB), it is not necessarily optimal in the (SB) as
the cost of implementation is greater in the second case.
In the (SB), implementing eH requires exposing the agent to risk, whereas in the (FB)
the agent is fully insured (although the expected utility, u0 , is the same in both cases).
The expected profit for the principal is higher in the (FB) as the expected value of
compensation is lower.
Relative to (FB), in the (SB) there is an efficiency loss on two margins (a) Distortion of
the effort choice: the principal may choose to implement eL rather than eH , even if eH
is optimal when effort is observable; (b) Agency cost: if it is optimal to implement eH in
the (SB) there is an agency cost is reflected in a lower utility for the principal and, thus,
a lower total surplus relative to (FB).
1.4
Applications
Agency problems arise in a wide variety of economic, political or social. Some examples are
discussed.
1. Company 1: The shareholders of a company delegate management to managers. In this
case the shareholders (the principal) do not know if the projects being decided by a
manager (the agent) maximize the value of the company or if, instead, they are projects
associated with a greater private benefits to the manager. Private benefits can either
3
In this model the agents surplus is always extracted by the principal. This is associated with the structure
of game. In particular, the principal offers a take it or leave contract to the agent, there is no possibility for the
agent to make a counter-offer. This implies that the principal has all the bargaining power. A more balanced
bargaining game would leave some surplus to the agent, but the qualitative conclusions regarding efficiency
-overall surplus loss and the potential distortion of the level of effort- would remain.
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13
take the form of low-effort (poor project choice), inefficient projects that benefit friends
or are perks associated with in kind to the manager (fame, cars, large headquarters, ...).
2. Company 2: Managers delegate tasks and function to eployees. This example is very
similar to that developed in the chapter. In this case the principal is a manager and
lower-ranked employees are agents.
3. Real estate: Homeowner delegate home sales to real estate agents. A real estate agent
spends on average 10% less time selling your house than he/she spends selling her own,
resulting in 3% lower prices (for example, $300,000 rather than $310,000).4
4. Democracy: Citizens delegate social decisions to government officials and parliamentarians. In this example, citizens are the principals and politicians act as agents or representatives. Typically, citizens do not have the same ideological preferences and therefore it
might be difficult to identify the principals objective in this example. Nonetheless, it is
clear that most citizens would agree in condemning corrpution. The fact that corruption
exists and that it can be significant in many countries, provides clear evidence of agency
problems in government.
It is worth noting that the alignment of politicians incentives with those of citizens (or at
least a significant group), may depend on institutions such as transparency laws, political
financing and the electoral system. Some political and regulatory systems induce more
accountability than others.
5. Parents and children. Education and nutritional decisions are made by parents and
impact greatly the wellbeing of children. In spite of parental authority, in this example,
the principal are the children and the agent or agents, are parents. While most parents
care for their children, raising and taking care of children requires considerable effort and
resources. Child abuse is an extremely sad example that illustrates the limitations of
parents altruism and how parental motivations may not necessarily along with the best
interest of the children.
Some of the social programs with the greatest impact in the last decade, conditional cash
transfers, explicitly take into account potential moral hazard problems. In Latin America, programs such as Chile Solidario (Chile), Bolsa Familia (Brazil), Progresa (Mexico),
among others, make subsidies are conditional on observable actions such as school attendance or yearly medical checkups. These observables at least ensure some minimum
caring standards for the children.
6. Moral Hazard and sub-prime loans. The Great Recession that has affected financial
markets and the global economy since 2007, began with the subprime loans crises. Part
of the problem was due to moral hazard in the screening of mortgages, the subprime
loans. In practice, many of these loans were aimed at a population of individuals that
had a high probability of not repaying loans.
4
Dubner and Levitt (2005) Freakonomics.
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14
What explains that banks gave out loans with a high likelihood of default? From the early
nineties banks started a process of securitization: banks created securities by tranching
the original mortgages into slices and then repackaging tranches of thousands of loans
into an asset; once sold to other financial intermediaries they gave holders claims to the
tranches of the loans originally generated by the bank. This meant that banks adopted
a strategy of generating mortgage loans and distributing securities based on those loans
to the financial market. This allowed banks to gain liquidity and, at the same time, to
diversify the idiosyncratic risks associated to the population they served. The downside
was that banks were overinsured: since the risk of the original loans were distributed
in the market, the banks faced little risk associated the loans they generated, reducing
the incentive to screen loans. Banks had an incentive o generate loans regardless the
solvency of the customer. The financial reform passed during the Obama administration
now requires banks to retain a significant fraction of the loans originated and face that
risk, solving, in part, this moral hazard problem.
7. Moral hazard in the credit market. The agent is an entrepreneur who needs a loan to
finance a profitable investment project. The principal is the bank, interested in the repayment of the credit and associated interest. A project can succeed or fail depending
on the effort and luck of the entrepreneur. The analysis in this chapter suggests that the
bank should provide incentives to reward effort in case of success and punish the agent
if the project fails. In practice, the punishment bad results is normally associated with
the requirement of a collateral. The risk of losing the collateral can be a strong incentive
for the entrepreneur to maximize the probability of success of the project.
However, contracts based on the existence of a collateral do not work for small businesses
or poor individuals who simply are wealth and liquidity constrained. In this context,
good projects that are in the hands of liquidity-constrained agents would receive no funding. This is inefficient and it has direct effects on the income distribution and poverty.
In other words, a market failure in the credit market may have important social and
productive consequences if the poorest individuals are rationed out due to asymmetries
of information.
The microfinance movement has emerged, in part, as an attempt to correct this market
failure. It uses information and collaterals that arise naturally in a community. Indeed,
many microfinance programs rely on group credits with joint liability: If two people get
loans and one of them fails, the other is partially responsible for the repayment. This
formula helps reduce to moral hazard because although the bank cannot monitor the
efforts made by its customers, the community has better information on the behavior of
its members. Further, if one of the involved parties failed to pay the credit it can receive
important social sanctions. For example, an individual can be ostracized and lose access
to social favors and social insurance (e.g. food, child care). This is a form of social
collateral, a collateral that is available only in the community (not for the bank). This
mechanism illustrates how social monitoring and sanctions may serve to overcome moral
hazard problems.
Imperfect Markets
1.5
15
Concluding remarks
We conclude this chapter by pointing out that there is a vast literature that seeks to extend
the agency model to incorporate important aspects of reality that were left out of our analysis.
For example, many jobs and enterprises are associated not only with one action but several.
In principle, a teachers efforts are directed not only to teach skills in a particular area but
may potentially involve many dimensions -teach math, teamwork, tolerance, moral reasoning,
communication, critical skills, tolerance, frustration management, etc... When an agent must
devote her attention and efforts to multiple tasks and efforts -multitasking- it is not obvious
how to encourage a task without discouraging others. For example, rewarding teachers whose
students achieve good scores in a standardized test focus the complex task of teaching to one
dimension crowding out attention from other dimensions. Even worse, it could induce some
degree of corruption such as preventing worst-performing students to attend school when there
is a standardized test or a black market for test questions. A different example involves companies that make decisions both about quality and cost innovations. If it is not easy to measure
the quality of a service, a provider may have incentives to reduce costs at the expense of quality.
Other aspects that we have ignored are related to intrinsic motivation. Many times people
strive at their jobs not because they have bonuses or high-powered incentive contracts. They
do so because it is the right thing to do or because they are passionate about what they do. It is
not obvious how important monetary incentives are to motivated agents. Recent advances seek
to establish precisely when monetary are incentives important and when not, and to identify
circumstances in which monetary incentives can crowd out intrinsic motivation.
1.6
Appendix
Proof of Proposition.
To prove the statement, we use a change of variables. Finding wB and wA is equivalent to
determining vB = v(wB ) and v = vA vB = v(wA ) v(wB ). Let (.) = v 1 (.) which is
strictly increasing and convex (for vis strictly increasing and concave). Using this notation we
rewrite the problem as
min (vB , v) = pH (vB + v) + (1 pH )(vB )
(vB ,v)
subject to
pv CH
pH v + vB CH u0
Once again, we see that (IC) is related to the establishment of a incentive bonus v. Given
a bonus level, (P) determines the base compensation vB .
Imperfect Markets
16
To see that (P) is a binding constraint at the optimum, assume, towards a contradiction, that
it is not. We find a profitable deviation for the principal, contradicting optimality. If (P) does
not bind, pH v + vB CH > u0 . Then, it is possible reduce vB and i vA by a small amount
> 0. For small enough, (P) is not violated (as we assumed it is not active). In addition, this
change does not alter the (IC) as v = vA vB + = vA vB . Thus, if the participation
constraint is not binding, it is possible to reduce the fixed component of the compensation
without affecting the effort incentives. Clearly it is beneficial to reduce the compensation for
the principal since it reduces the expected cost of implementation. This profitable deviation,
yields the desired contradiction. We conclude that (P) must bind at the optimum.
To show that (IC) binds, assume that it is not. Then pv > CH . It is possible to reduce
the bonus v by a small amount > 0 and raise vB by pH . For small enough, the strict
inequality assumed for (IC) is reduced but without violating this constraint. Furthermore, this
change -by construction- does not affect (P). To conclude that (IC) binds it must be that this
change in compensation generates less cost to the principal, so that it is profitable. Using a
first-order Tayor approximation for small, we obtain (vB + pH , v ) (vB , v) +
vB pH v . It follows that the two middle terms are
pH

vB
v
= (1 pH )pH [0 (vB ) 0 (vB + v)].
(vB + pH , v ) (vB , v) =
The convexity of implies 0 (vB + v) > 0 (vB ), which combined with the above yields
the conclusion that (vB + pH , v ) < (vB , v). Therefore, the change in the contract
designed reduces the value of the expected compensation and is beneficial for the principal.
This allows to conclude that (IC) binds. The proof is complete.
Imperfect Markets
Chapter 2
Adverse Selection, Signaling and

Screening
In this chapter we analyze asymmetries of information associated with a hidden characteristic
or quality. Frequently, the characteristic that defines a good or service is better known by one
of the sides of a market, that is, one party has private information on the quality of that good
or service. In the used cars market, the supplier has better information about the quality of
the product. In the labor market, a worker may know better her own skills than a potential
employer. In a medical insurance market, a buyer has more information regarding his health
risks than an insurer.
In all of these markets, the asymmetry of information impedes the existence of separate
markets for each of the different types. In the used car market, cars in good condition are
potentially confounded with cars sin poor condition. Similarly, prior to hiring someone, it
might be hard to distinguish between high and low productivity workers for a particular job
without incurring in a cost -a selection process, for example. An insurer may not (and, perhaps,
should not) distinguish between individuals with different risk profiles. As we will see, private
information on hidden characteristics can lead to adverse selection, i.e., it can reduce market
transactions to a subset of types, lead to rationing or even no transactions at all. We discuss
some government remedies to adverse selection. Market solutions such as signaling or screening
that allow for private information to be disclosed in a market equilibrium are also analyzed.
As we discuss later, this information revelation will typically be associated with potentially
significant transaction costs.
Unlike moral hazard, in which the information asymmetry is linked to an endogenous decision, in the case of hidden characteristic the private information is linked to an exogenous
characteristic. Another difference is that hidden characteristic lead affect to selection and rationing prior to the exchange or signing of a contract while the moral hazard problem associated
with a hidden action takes place after the signing of the contract.
17
18
We begin with simplified model of the market for lemons (Akerlof, 1970), a seminal
model. Two additional examples follow, the insurance and labor markets. The rest of the
chapter analyzes policy and market solutions to the adverse selection problem.
2.1
The Market for Lemons
Consider a market for used cars. There are an equal number of buyers and sellers, one hundred.
It is public knowledge one half of the cars are low quality, lemons, and the other half are high
quality, peaches. It is assumed that buyers and sellers are risk neutral.1
If p is the market price of a used car, the utility of a seller is U T = p if he trades the car.
Otherwise, if he does not trade, the owner gets a reservation value u0 associated to keeping
the car. Hence, a seller is willing to sell if and only if p u0 . The reservation value is higher
for peaches than it is for lemons. For illustration, it is assumed that u0 = $1, 000 if the car is
lemon and u0 = $2, 000 if it is a peach.
When the buyer is certain about quality of the car, buying the car gives him a utility of
U = p, where is the consumers valuation of the car. The valuation of the car for a potential buyer varies according to the quality of the product. Hence, we can identify the unobserved
quality of the car with the valuation of the consumer. We assume that = 2, 400 if the car is
peach and = 1, 200 for a lemon. The valuations of buyers and sellers are summarized in the
following table.
Valuations
Sellers reservation value (u0 )
Consumer valuation ()
Lemons
1, 000
1, 200
Peaches
2, 000
2, 400
In principle, the potential buyer does not observe the quality of the car. Hence, in deciding
whether or not to purchase a car he considers the expected utility EU = e p, where e
is the expected valuation of the cars that are traded. If is the set of cars that are traded,
then e = E[|]. For example, if all the cars are traded, then = {peaches, lemons} and
e = E[|] = 12 1, 200 + 21 2, 400 = 1, 800. If instead, only lemons are traded, = {lemons}
and e = E[|] = 1, 200. It is assumed that if the potential buyer does not participate the
business, will have a utility equal to zero. Therefore, a consumer will buy a car if and only if
EU 0 or equivalently, e p.
An important assumption of this model is that buyers have rational expectations. This means
that after observing the market price p, a consumer takes into account the optimal behavior of
1
Aside from simplifying the exposition, this shows that, in contrast to the principal-agent model, risk aversion
is not central to the adverse selection problem.
Imperfect Markets
19
sellers to infer which type of cars would be offered at that price. In particular, for each price p,
the potential buyers infer the set (p) of types that would trade at p and, from this inference,
they determine their maximum willingness to pay e (p) = E[|(p)].2
A market equilibrium price p is such that:
1. For those sellers who trade, the price weakly exceeds their reservation value: for each
(p ), u0 () p .
2. Consumers willingness to pay weakly exceeds the price: e (p ) p
We can define the willingness to accept function, W A(p), as the maximum reservation
value of the types that participate in the market at a given price p. Formally, W A(p) =
max{u0 ()| (p)}. Any price p that satisfies
e (p ) p W A(p ),
is an equilibrium price. Thus, in equilibrium, the willingness to pay of consumers is at least
the market price and the willingness to accept of sellers is at most that same price.
We start by analyzing the market equilibrium for the benchmark case in which there is no
private information, i.e., car quality is observed by the buyer (First Best). We next study
the case in which there is private information and only the seller knows the quality of the car
(Second Best).
2.1.1
First Best: Complete information, observable quality
In rigor, peaches and lemons are different goods. If the quality of the car is public knowledge,
lemons and peaches can be distinguished as different goods. Hence, without asymmetries of
information, there will be two markets, one for each type of car.
1. Lemons market
The supply is determined by the sellers reservation valuation, which can also be interpreted as an opportunity cost. The demand curve can be identified with the consumers
willingness to pay for a lemon, namely 1,200. Any price p [1, 000, 1, 200] clears the
market. Different equilibrium prices determine how the total surplus from exchange is
distributed between sellers and buyers but it does not affect total surplus from exchange
2
Note that, in models without asymmetries of information, such as classical consumer theory, the willingness
to pay reflects only consumer preferences (e.g. the marginal or incremental utility of a good). In contrast, in
this case the willingness to pay depends e (p) on the market price because the price delivers information about
the unobserved quality of the goods traded.
Imperfect Markets
20
which is given by 50 200 = $10, 000.

[Insert Graphic equilibrium in both markets]
2. Peaches market
In this market, consumers are willing to pay 2,400 for each car. The opportunity cost of
suppliers is 2,000. Thus, any price p [2000, 2400] is an equilibrium price and the social
surplus associated with the transactions is 50 400 = $20, 000.
If lemons and peaches can be distinguished and are sold in separate markets, all goods for
which there is a willingness to pay that exceeds its opportunity cost are traded. The social
surplus generated in the two markets is 10, 000 + 20, 000 = $30, 000.
2.1.2
Second Best: Asymmetric Information, quality is private information
With asymmetric information only sellers know if a car is a lemon or a peach. Since buyers
cannot distinguish between different types of cars, there is a single market for used cars to
allocate two different goods.
Recall that the seller is willing to sell if and only if p u0 and a potential buyer is willing to
buy if and only if e (p) p.
To characterize the equilibrium in this market, it is convenient to analyze the decisions of
buyers and sellers for different market prices.
1. Suppose p [0, 1, 000)
a) Sellers: No one is willing to sell since p < 1, 000 < 2, 000.
b) Buyers: In this case, (p) = .
Although at this price consumers are willing to buy any car, no cars not traded.
2. Supposep [1, 000, 1, 200]
a) Sellers: Lemon owners are willing to sell as p 1, 000. Peach owners do not trade since
p < 2, 000.
b) Buyers: Buyers infer that (p) = {lemons} and therefore their willingness to pay is
e (p) = 1, 200. In other words, they are willing to pay the valuation of lemons.
In this case, any price p is a market equilibrium and only lemons are traded market. Indeed, observe that W A(p) = 1, 000 and since e (p) = 1, 200., we have that
e (p ) p W A(p ).
The equilibrium reminds the first-best outcome, as it reproduces the equilibrium in the
lemons market when quality is observable. However, there is a crucial difference: no
Imperfect Markets
21
peaches are traded. The information asymmetry produces adverse selection, the market
for used cars is a market for lemons, peaches are crowded out of the market.
3. Suppose p (1, 200, 2, 000)
a) Sellers: Only lemons owners would be willing to sell, since 1000 < p < 2, 000.
b) Buyer: As before, buyers infer that (p) = {lemons} and therefore e (p) = 1, 200.
Consequently, no one would be willing to buy as e (p) < p.
That is, as the willingness to pay for lemons of potential buyers is less than the price they
face, so choose not to participate in the market. Therefore, for any price in this range
there is no trade and no equilibrium.
4. Suppose p 2, 000
a) Sellers: All sellers would be willing to sell because the price exceeds the reservation
value of the peaches (and, thus, also the one of lemons).
b) Buyers: Buyers infer that (p) = {peaches, lemons}. Hence, e (p) = 1, 800. Since
e (p) < p, no one is be willing to buy.
While both types of cars would be offered, the price is too high for consumers and
no transactions take place. As we will see shortly, this conclusion is sensitive to the
parameters of the model. In particular, if the fraction of lemons were lower making the
average valuation increase, it is possible to have an equilibrium in which all cars are
traded.
The table below summarizes the previous analysis.
Price
p < 1, 000
# Transaction
0
Sellers
No one willing to
sell
Only lemon owners willing to sell
1, 000 p 1, 200
50 Lemons
1, 200 < p < 2, 000
Only lemon owners willing to sell
2, 000 2, 000
All willing to sell
Buyers
Buyers willing to
buy any car.
Inferring
that
only
lemons,
are offered, participate in the
market.
Inferring
that
only
lemons
are offered, no
willingness
to
partipate.
Knowing that all
cars would be offered is not attractive enough.
We conclude that, for these parameters of the model, any p [1, 000, 1, 200] is an equilibrium
price and these are the only equilibria. In any such equilibrium, a only lemons are traded: the
Imperfect Markets
22
used car market is a market for lemons and there is a welfare loss associated to the fact that
peaches are not traded.
2.1.3
Analysis
By comparing the results of the First Best to the Second Best we conclude that when the
quality of the traded good is not publicly known, the market may fail to allocate resources
efficiently. Only lemons are traded while the willingness to pay for peaches is greater than
their opportunity cost. The loss of efficiency is measurable, it is the difference between social
surplus obtained with asymmetric information and the social surplus in the first best. It
corresponds exactly to the social surplus associated with the exchange of peaches:
Inef f iciency = 30, 000 10.000 = $20, 000.
This market failure is usually referred as adverse selection because only low quality cars traded.
Importantly, rational expectations play a key role in this model. When a seller decides whether
or not to participate in the market, it changes the perception of the buyer with respect to
the quality of the cars that are exchanged. When a lemon car owner decides to participate in
the market, the willingness to pay falls, generating an informational externality. This hurts
peaches car owners to the point of crowding them out the market.
Is there always adverse selection when the quality of the good is private information? No. For
example, assume that the proportion of lemons and peaches is 0.25 and 0.75, respectively. In
this case E[] = 0.25 1, 200 + 0.75 2, 400 = 2, 100. Consequently, any price p [2000, 2100]
will be a market equilibrium and all cars are traded. In fact, these prices exceed the reservation
value of the sellers of peaches and at the same time, (p) = {peaches, lemons}, so that the
willingness to pay is e (p) = 2, 100 p. In general, if the proportion of lemons is less than 13
there are two equilibria: in addition to the equilibrium adverse selection, there is an equilibrium
in which all cars are traded .
If there are multiple equilibria, the social surplus is higher in the equilibrium with more trade.
2.2
Adverse selection in insurance markets
We start with a numerical example of the market for car insurance. A more general model is
presented in the sequel. In this case the hidden characteristic is a drivers ability. We assume
that in the market there are 2000 drivers, 50% are good drivers and 50% are bad. A good
driver is characterized by a lower probability of an accident than the bad driver. Thus, for the
same coverage, a bad driver -who has a a higher likelihood of an accident- is willing to pay
more for insurance. The probability of an accident and the valuation of insurance for each type
of driver is described by the table below.
Imperfect Markets
(a) = 0.5
23
(b) = 0.75
Figure 2.1: Equilibrium Analysis
Willingness to pay for insurance

Probability of an accident
Bad driver
11, 600
0.20
Good driver
2, 975
0.05
An insurer obtains a (per unit) expected profit = M C, where M is the premium charged
for insurance and C is the expected cost of reimbursing a customer for an accident. We assume that insurance companies are risk neutral. In case of an accident, the insurance covers
a fixed amount equivalent to a loss of $50,000. That is, the coverage is $50,000 if there is
an accident and $0 otherwise. Finally, we assume that the insurance market is competitive.
This means that, in equilibrium, firms will have a zero expected profit ( = 0 M = C).
It is also assumed that the seller has rational expectations. This implies that, if the insurer
is unable to distinguish between different types of drivers, he will calculate the expected cost
of coverage C taking into consideration the participation of good and bad drivers in the market.
As in the previous example, we first analyze the case of complete information.
2.2.1
First Best: Complete information
Suppose that insurance companies know with certainty the type of driver it faces. Since the
seller can distinguish whether the client is a good or a bad driver, there are two separate insurance markets: one for good drivers and one for bad drivers. In each market firms must
make zero expected profits in equilibrium. Hence, the market premium is equal to expected
cost of coverage. For good drivers, the expected cost is CB = 0.05 50, 000 = $2, 500 and for
bad drivers this cost is CA = 0.20 50, 000 = $10, 000. It follows that insurance premium in
each market are given by MB = CB = $2, 500 and MA = CA = $10, 000, respectively. In both
Imperfect Markets
24
markets, the prices are lower than the willingness to pay of potential customers (2, 975 > 2, 500
and 11, 600 > 10, 000), therefore, all drivers are insured.
If the drivers ability is public information, the total surplus per driver associated with both
types of drivers is 1000 (11, 600 10, 000) + 1000 (2, 975 2, 500) = $2.075 millions.
2.2.2
Second Best: Asymmetric information
In this case insurance sellers cannot distinguish the riskiness of drivers. In principle, good and
bad drivers would buy their insurance in the same market at the same price. If all drivers
participate, the average expected value of repayment C depend on the distribution of good and
bad drivers. Since there are as many good drivers as bad ones,
C = 0.5 CB + 0.5 CA = 0.5 0.20 50, 000 + 0.5 0.05 50, 000 = $6, 250.
In a competitive market this value would also be the insurance premium M .
However, good drivers will be unwilling to pay this premium, M = $6, 250, as it exceeds their
willingness to pay, $2,975. They would not participate in the market. The seller, anticipating
that a good driver would not buy insurance, would not offer this premium as it does not cover
the expected cost of covering the bad driver is CB = $10, 000. In fact, knowing that good
drivers do not participate in the market, insurers would offer a premium M = C = $10, 000.
Hence, only bad drivers are insured and there is rationing or adverse selection.
Just as in the market for lemons example, adverse selection involves an efficiency loss. In this
case, the total surplus transactions is 1000 (11, 600 10, 000) = $1.6 millions. The difference
with respect to the first best is $0.475 millions. This amounts to the social surplus associated
to good drivers, who are now crowded out of the market.
As before, for a different distribution of types there need not be adverse selection. For example,
if the share of high-risk drivers is 5%, the average expected value of repayment is C = 0.05
0.20 50, 000 + 0.95 0.05 50, 000 = $2, 850. In this case, low-risk individuals are willing to pay
for insurance and a pooling equilibrium in which all individuals buy insurance and are charged
the same premium exists.
2.3
Insurance market, a model
We consider a formal model of the insurance market. Assume that there are two types of
individuals who want insurance, high risk and low risk individuals. The probability of an
accident of a high risk individual is A and for a low risk this number is B . It holds that
Imperfect Markets
25
0 < B < A < 1. The initial wealth of the individual is W and if an accident occurs he would
suffer a loss of L. If the individual is not insured and an accident occurs, his final wealth is
W L. (In the example of previous section L = 50, 000.)
In general, the wealth levels with or without an accident will depend on the insurance. In fact,
an insurance lowers the difference in wealth between the good and bad states. Let W1 and W2
be the wealth levels without and with an accident, respectively. If v() is the Bernoulli utility
function of a typical consumer, v() increasing and concave, his expected utility is given by
U (W1 , W2 ) = (1 ) v(W1 ) + v(W2 ),
In particular, the utility without insurance is
U N () = (1 ) v(W ) + v(W L) = v(W ) [v(W ) v(W L)],
which is decreasing in the level of risk .
On the supply side, in principle, a seller can design a contract described by the pair (M, D),
where M is the premium and D is the deductible. The deductible is the amount of the loss is
not covered by insurance, so that the reimbursement in the event of an accident is L D. For
each insurance contract the seller gets a profit = M C = M (L D). Note that if the
applicant purchases the insurance, then his wealth will be W1 = W M and W2 = W M D.
Thus, setting a contract (M, D) amounts to setting the individual wealth levels (W1 , W2 ).
Full or perfect insurance is a contract such that the individual faces no risk. That is, W1 = W2
or equivalently, a zero deductible, D = 0. In this case, the expected coverage is C = L and
the sellers expected profit is = M L. Hereafter, for simplicity, we consider that the only
insurance available in the market is perfect insurance. In this case, individual wealth levels are
such that W1 = W2 = W M irrespective of whether or not an accident occurs.
We note that the maximum willingness to pay for full insurance for an individual of type
corresponds to the value M () that makes him indifferent between buying the insurance with
thet premium and not buying the insurance:
v(W M ()) = U N ().

For illustration, if v(z) = z then M () = 2(1 )(W W W L) + 2 L. Moreover,

suppose that W = 90, 000 and L = 50, 000. Then, for = 0.2 we obtain M () = 11, 600 and
for = 0.05, M () = 2, 975. These are precisely the values used in our numerical example.
It can be shown, by differentiating the above equation with respect to , that the willingness to pay for insurance grows with the probability of an accident . Intuitively, given the
same level of insurance, the individual more likely to have an accident values the insurance more.
Imperfect Markets
2.3.1
26
First Best: Perfect Information
In this case, the insurer can perfectly identify customers according to their risk level. This
allows insurers to offer different contracts for each type of customer. If the market is perfectly
competitive ( = 0), the premium set for a customer of type is M () = L. If the consumer
takes this contract, then W1 = W2 = W L , i.e., completely eliminate the risk. In fact,
this contract allows the buyer to enjoy a wealth level W L with certainty. This is the
expected wealth level of the individual if he does not buy insurance. The difference is that,
without insurance, this wealth level is not certain. By the definition risk aversion, a risk averse
individual will always take the insurance at that price. In mathematical terms,
]) = v(W L) > E[v(W
)] = (1 ) v(W ) + v(W L)
v(E[W
This is always true for any function v(.) strictly concave.3
2.3.2
Second Best: Imperfect Information
In this case, the insurer cannot identify customers according to their level of risk, and there is
single insurance market for low and high risk individuals. Since high-risk agents have a higher
willingness to pay for the same insurance (only perfect insurance contracts are offered), we have
that if low-risk individuals are then secured so do the more risky. It follows that there can be
two types of equilibria.
1. Equilibrium with Rationing/Adverse selection

In this case, only high-risk individuals ( = A ) are insured. In the lemons market and
the numerical insurance examples seen earlier, this case corresponds to the equilibrium
in which only sold lemons or just bad drivers are insured. The market premium is
M AS = A L. This adverse selection equilibrium requires that low-risk individuals prefer
remaining without insurance, i.e.,
U N (B ) > v(w A L),
where U N (B ) = (1 B ) v(W ) + B (v(W L)). This condition is equivalent a
willingness to pay of low risk individuals smaller than the expected loss of a high risk
individual. That is, M (B ) < A L. In our numerical example, M (B ) = 2, 975 and
A L = 10, 000, so this condition holds.
2. Pooling equiibrium
In this case, all potential market buyers participate. Since the seller cannot distinguish
the two types of consumers, it offers a single contract. By assumption, we are only
3
Since the right hand side is just the expected utility without insurance U N (), and the willingness to pay
M () satisfies v(W M ()) = U N (), the unequality is equivalent to v(W L) > v(W M ()). Equivalently,
M () > L, that is, a risk averse individual is always willing to pay more than the expectted loss.
Imperfect Markets
27
considering perfect insurance and, since the market is competitive, the premium of this
insurance must be M pooling = E[] L. Note that if the fraction of individuals of type A
is , then E[] = A + (1 )B , a number between B and A . Since, M AS = A L,
we have that M pooling < M AS .
For this to be an equilibrium, the low-risk individual should have incentives to take the
insurance, i.e.,
V (w E[]L) U N (B )
This condition is equivalent to require the maximum willingness to pay of low-risk individuals to exceed the average expected loss: M (B ) E[]L. In our numerical example,
M (B ) = 2, 975 and, for = 0.5, E[]L = 6, 250, so this condition is not satisfied.
However, if = 0.05 then E[]L = 2, 850, and the condition holds.
In general, for sufficiently low values of there will be multiple equilibria, i.e., both the
adverse selection and the pooling equilibrium exist.
For some values of the parameters both equilibria are possible. If there are multiple equilibria, the equilibrium in which the two types of agents receive insurance Pareto dominates the
equilibrium with rationing. To see why, we start by noting that in any equilibrium insurers
get zero utility (competitive markets). Moreover, low-risk individuals get a utility U N (B ) in
the equilibrium with rationing and, by revealed preference, in the equilibrium in which all are
insured they get a higher utility. Finally, individuals of type A get the same insurance in both
equilibria but in equilibrium with rationing they pay a higher premium as M AS > M pooling .
2.4
Signaling and Screening in the Labor Market
We want to illustrate two market responses to the problems associated with hidden characteristics: signaling and screening. The case of signaling involves a costly action -the acquisition
of a signal- from the part of the market holding the private information. The value of a signal
to the informed party is that it allows this party to distinguish from other types. For example,
a quality certification can separate one firm from another offering a similar but lower quality
product. A diploma or a college degree may signal skills or competencies that are not directly
observable at the time of hiring.
Screening is associated with actions by the uninformed party in the market to learn the
private information.
Both signaling and screening allow private information to be revealed in equilibrium. However,
as we shall see, the fact that the information ends up being revealed ex-post does not mean that
there are no efficiency losses associated with ex-ante information asymmetries. Both signaling
and screening will typically be associated with transaction costs.
We illustrate these phenomena with a model of the labor market. We assume that when a firm
hires a worker it does not know his or her innate ability or productivity. Worker productivity
Imperfect Markets
28
is private information and can be high and equal to A or low and equal to B , where A > B .
To fix ideas, we assume that A = 300 and B = 200. The fraction of high productivity workers
is and the fraction of low productivity workers is 1 .
Firms use only labor to produce and have constant returns to scale. This means that the profits
of hiring a worker of productivity are given by w, where w is the wage that the firm pays.
We consider a competitive market in which firms compete to hire workers: in equilibrium, firms
make zero profits.
A worker is risk neutral. If his or her type is , the Bernoulli utility is given by
u(w, a, ) = w C(a, )
where w is the wage and C(a, ) is the cost of an action a. In the case of signaling, we assume
that this action corresponds to the choice of a level of education, the signal. In the case of
screening, we assume that it corresponds to a task level chosen by the hiring firms.
2.4.1
Education as signaling
The classic model of Spence (1974) suggests that education can serve as an informative signal of
the unobserved productivity of a worker. For simplicity, to highlight this role, we assume that
education does not increase productivity at all, it just has informative value. The qualitative
conclusions would not change if education has also a productive role.
We consider a game with the following sequence of actions:
1. Nature chooses the type of the worker, only the worker observes his type.
2. After observing , the worker decides a level of education that can be 0 or e > 0. We
interpret this level as the years of higher education.
3. Firms observe the level of education and offer a wage w(e) contingent on e.
4. The worker decides whether or not to accept the offer.
The key assumptions are the following:
It is costly to produce the signal: C(0, ) = 0 y C(
e, ) > 0
The cost of education is lower for high productivity workers than for low productivity
workers. In particular, assume that
C(e, ) = c()
e
where c() is the unit cost per year of education. If cA = c(A ) is the cost for someone
with high productivity and cB = c(B ) of someone with low productivity, this translates
into cA < cB .
Imperfect Markets
29
As a reference, we start by noting that if productivity were observable (no asymmetries of information), firms would pay a wage equal to productivity. That is, there would be two markets,
one for each type of worker and the equilibrium wages in each market would be wA = A = 300
and wB = B = 200.
We consider two possible types of equilibrium, pooling and signaling (or separating equilibrium).
Pooling equilibrium
In a pooling equilibrium, both types of workers receive the same salary wpooling . The zero profit
condition for firms implies that the wage is equal to the expected productivity, i.e.,
wpooling = E[] = 300 + (1 ) 200.
The utility of each worker is precisely equal to u = E[], independent of the type. Relative to the
case where productivity is observable, low-productivity workers are better and high productivity
are worse because their salaries are dragged down by the fact that their productivity is pooled
with the one of lower productivity workers.
Signaling equilibrium
In what follows we characterize the conditions for the existence of a separating equilibrium
in which low-productivity workers chose not educate -no investment in signal, high productivity workers educate -signal- and firms offer different wages depending on the signal they observe.
Before observing the signal, the a priori probability that a firm assigns to a high-productivity
worker is . In a signaling equilibrium, after observing the education level of a worker, the firm
updates its belief on the (unobserved) productivity of the worker. If (e) is the probability
that a firm assigns the worker to be highly productive after observing a level of education e, in
a separating equilibrium, (e = e) = 1 and (e = 0) = 0 . In a competitive market, firms offer
wages equal to expected productivity. Consequently, if w(e) is the wage offered after observing
a level of education e, w(e = 0) = B = 200 and w(e = e) = A = 300.
In separating equilibrium, no education (e = 0) must be a best response for a low productivity
worker ((B ) and education (e = e) must be a best response for a high productivity worker
(A ).
The incentive compatibility condition for a worker of type B is:
u(w(0), e = 0, B ) u(w(
e), e = e, B ) 200 300 cB e cB e 100.
(ICB )
The condition simply says that, for B , the cost of the signal is not compensated by the benefit
of the signal corresponding to a wage increase measured by the difference between the two
Imperfect Markets
30
productivities.
The incentive compatibility condition for a worker of type A is:
u(w(
e), e = e, A ) u(w(0), e = 0, A ) 300 cA e 200 cA e 100.
(ICA )
For A , the benefit of the signal exceeds its cost.

To fix ideas, suppose that cA = 20 and cB = 25. The (ICB ) condition translates into e 4
while the (ICA ) condition requires e 5. That is, there is a range for the level of education
and to work as a signal: it must be greater than 4 years -sufficiently high to discourage B and less than five years -not too excessive for A to be interested to incur in that cost.
Figure 2.2: Signaling
Welfare Analysis
How does the economic welfare of the agents in the signaling equilibrium compare with the
case in which productivity is directly observable?
In this example, education has no productive value, its only function is informative.
Given this, the cost of the signal is pure social loss. With the numbers above, e = 4
Imperfect Markets
31
is the minimum level required for a separating equilibrium to work. For this case, the
equilibrium utility for each type of worker usA = 300 20 4 = 220 and usB = 200.
Accordingly, the type A is strictly worse than if productivity were observable. There is
a transaction cost equal to 80, the cost of the signal.
Signaling allows for private information to be disclosed and, in practice, it recovers the
existence two labor markets. But this is not free, there is a cost associated with the
original information asymmetry.
How does the economic welfare of the agents in the signaling equilibrium compare to a pooling
equilibrium?
Low productivity workers are worse off. As before, the do not educate (i.e., do not incur
the cost of the signal) but are paid less.
While motivation for signaling is that high productivity workers can distinguish themselves from lower productivity ones, it is not clear that they are better in the signaling
equilibrium vis a vis the pooling equilibrium. In fact, they are better only if:
upooling = E[] = 300 + (1 ) 200 usA = 220 0, 2.
That is, if the fraction of high productivity is high ( > 0, 2), so that the average productivity is relatively high, a high productivity worker would prefer not to signal. In
this case, the pooling equilibrium Pareto-dominates the signaling equilibrium. Paradoxically, individuals are trapped in an equilibrium that reveals the information, but it is
unequivocally worse than one in which there is no disclosure.
2.4.2
Screening competitive in the labor market
The central idea of screening is that the uninformed party -firms in this example- can induce
the informed party -the worker- to disclose information by offering a menu of options. This
menu leads different types to choose different options in the menu. Separation and information
disclosure occurs by self-selection into different options. The screening mechanism is contextdependent. In the labor market, one way to screen is to offer contracts that include, in addition
to a compensation w, a task t that allows to discriminate (a screening test, for example, or a
specific task to reveal competencies).
We consider a game, similar to previous one, with the following sequence of actions:
1. Nature chooses the type of the worker, only the worker observes his type.
2. The firms offer a menu of contracts simultaneously. In particular, each firm offers two
contracts: CA = (wA , tA ) and CB = (wB , tB ) where wj is the compensation and tj is the
level of the task. In principle, firms can offer different menus with different contracts,
but in equilibrium all will offer the same menu. Each contract Cj is designed to attract
a worker of type j , j = A, B.
Imperfect Markets
32
3. The worker decides which contract to accept.

The utility of an agent of type if he accepts a contract (w, t) is u(w, t, ) = w C(t, ).
The key assumptions are:
A task level t has a cost C(t, ) where C(0, ) = 0 and C(t, ) > 0 for t > 0.
The cost of the task is less for high productivity workers. In particular, assume that
C(t, ) = c()t.
If cA = c(A ) is the unit cost for someone with high productivity and cB = c(B ) of
someone with low productivity, this translates into cA < cB .
For simplicity, we assume that the task does not affect the profit of the firm. This means
that the expected profits of the firm are (A wA ) + (1 )(B wB ). That is, the firm is
interested in minimizing the expected compensation wA + (1 )wB , which only depends on
wj . This does not mean that the tasks tj are irrelevant. In fact, differentiating tasks allows
contracts to induce self-selection. For this to happen, contracts must satisfy the following incentive compatibility constraints.
The incentive compatibility condition for a worker of type B is:
u(wB , tB , B ) u(wA , tA , B ) wB cB tB wA cB tA
(ICB )
The incentive compatibility condition for a worker of type A is:

u(wA , tA , A ) u(wB , tB , A ) wA cA tA wB cA tB
(ICA )
In principle, it could be that there are two types of equilibria: a pooling equilibrium in which
both types are offered the same contract; and a separating equilibrium in which each type is
offered a different contract, inducing self-selection. The following proposition summarizes the
results of the screening model.
Proposition 2. In the model of screening in the labor market
1. There is no pooling equilibrium. If an equilibrium exists, it is a separating equilibrium.

2. In a separating equilibrium:
The low productivity worker accepts the contract CB = (B , 0).
The high productivity worker accepts the contract CA = (A , tA ) where tA = (A
B )/cB .
Imperfect Markets
33
To see that there is no pooling equilibrium, suppose that there is one. We will see that there
are incentives for firms to deviate, which means it cannot be an equilibrium. Indeed, if there is
a pooling equilibrium, as firms must make zero profit (competitive market), the wage offered
must be equal to the expected productivity: w = E[] = A + (1 B )B . This means that
firms are making a strict gain on high productivity workers (A E[] for each) and a strict
loss on low productivity (B E[] for each). The gain and the loss net out. Consequently,
a firm can cream skim the market and attract only high-productivity workers by offering a
slightly higher wage w + and a task t + also slightly higher. As the cost of the tasks differs across workers of different type, can be chosen high enough so as to attract only high
productivity workers. Thus, the firm will make a profit A E[] > 0 for small. Therefore, in a situation of pooling, cream skimming is a deviation that is strictly beneficial for a firm.
Figure 2.3: Skimming

In a separating equilibrium in which firms earn zero profits, firms must pay each type of worker
a wage equal to their productivity. That is, wA = A and wB = B . To understand why the
task of the type of low productivity is tB = 0, observe that if in equilibrium firms offered a
contract with tB > 0, a firm could deviate by offering a contract with a lower task level tB = 0
and improve its profit. For example, by offering a wage somewhat smaller than B , say B
the firm would continue to attract workers as they are more than compensated by a lower task.
The firm would increase profits as it pays lower salaries. Therefore, for this deviation not to
occur, it is necessary that tB = 0. Intuitively, in the background firms compete a la Bertrand,
pushing the task level down to a minimum.
Imperfect Markets
34
Figure 2.4: Competition

Finally, the task tA in the contract accepted by a high productivity worker is the minimum
that can satisfy incentive compatibility for type B , (ICB ). Indeed, the firm could offer lower
wages to a high productivity worker if it also decreases the level of the task to compensate him.
This increases the firms profit. However, the firm cannot go to far as it needs to prevent low
productivity workers to choose the high productivity contact.
Figure 2.5: Equilibrium Contracts

As in the case of signaling, we conclude that screening allows the disclosure of private information. In this case, a menu of contracts that satisfy incentive compatibility constraints induces
Imperfect Markets
35
self-selection, but it does so at a has a cost. Indeed, the high productivity agent pays cost of
doing a task without productive value. The transaction cost is cA tA = ccBA (A B ). If we use
the same numbers as in the case of signaling, cA = 20 and cB = 25, the transaction cost is
0, 8(300 200) = 80. This amounts to the same as signaling cost that allows for a separating
equilibrium in our signaling example.
Imperfect Markets

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Moral Hazard and Adverse Selection

Moral Hazard and the

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the management-management-agents to make decisions affecting the destiny of the company.

The Principal-Agent Model

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Harvard Kennedy School - FEN, Universidad de Chile

V (e, wA , wB ) = E[U (w,

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(eH , wA (eH ), wB (eH )).

Example: The trade-off between incentives and insurance

First Best: Observable effort

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to w0 such that v(w0 ) CH = u0 or w0 = 19 w0 = 361. The expected utility of the principal

Second Best: asymmetric information, non-observable effort

wA = 900 with probability 0.6

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That is, wA = $150 and

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The optimal contract

First Best: Observable effort

Second Best: Asymmetric information, non-observable effort

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The optimal contract that implements eH solves

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Figure 1.1: Optimal Contract

The optimal effort level

If H L 0, then it is optimal for the principal to implement eH , while if H L 0,

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Harvard Kennedy School - FEN, Universidad de Chile

Dubner and Levitt (2005) Freakonomics.

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Harvard Kennedy School - FEN, Universidad de Chile

Harvard Kennedy School - FEN, Universidad de Chile

vB pH v . It follows that the two middle terms are

Adverse Selection, Signaling and

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The Market for Lemons

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First Best: Complete information, observable quality

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which is given by 50 200 = $10, 000.

Second Best: Asymmetric Information, quality is private information

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1, 200 < p < 2, 000

Only lemon owners willing to sell

All willing to sell

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Adverse selection in insurance markets

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Figure 2.1: Equilibrium Analysis

Willingness to pay for insurance

First Best: Complete information

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Second Best: Asymmetric information

Insurance market, a model

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For illustration, if v(z) = z then M () = 2(1 )(W W W L) + 2 L. Moreover,

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First Best: Perfect Information

Second Best: Imperfect Information

1. Equilibrium with Rationing/Adverse selection

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vB pH v . It follows that the two middle terms are