ECON 632 Intermediate Microeconomics

Week 12: Asymmetric Information and

Contract theory
AsymmetricInformation:
Problemsduetoasymmetric
information
Responsestoadverse
selection
Howignoranceabout
qualitydrivesouthigh
qualitygoods
Problems Due to Asymmetric Information

Adverseselectionisopportunismcharacterizedbyaninformed
personsbenefittingfromtradingwithalessinformedpersonwho
doesntknowaboutanunobservedcharacteristic oftheinformed
person.
Example:peoplewhobuylifeinsurancepoliciesarebetterinformed
abouttheirownhealththaninsurancecompaniesare.
Adverseselectioncreatesamarketfailurebyreducingthesizeofa
marketoreliminatingit.
Moralhazardisopportunismcharacterizedbyaninformedpersons
takingadvantageofalessinformedpersonthroughanunobserved
action.
Example:insuredpeoplemayengageinriskybehaviorsthat
increasetheprobabilityofclaimsagainsttheinsurancecompany.
Responses to Adverse Selection
1.ControllingOpportunisticBehavior
Adverseselectioncanbepreventedifpeoplehavenochoice.
Examples:Agovernmentcanprovideuniversalhealthinsurance
coverage;firmsprovidehealthinsurancebenefitstoallemployees;
manystatesrequiredriverstocarryautoinsurance.
2.EqualizingInformation
Anuninformedpersonmayengageinscreening[research]to
determineinformationheldbyinformedpeople(e.g.testdrivinga
car)
Aninformedpartymayengageinsignaling tosendinformationto
alessinformedperson(e.g.firmdistributingfavorablereportonits
productbyanindependenttestingagency)
Lemons Market with Fixed Quality
Carsthatappeartobeidenticalontheoutsideoftendiffer
substantiallyinthenumberofrepairstheywillneed.
Somecars,lemonsastheyarecalled,haveavarietyofinsidious
problemsthatbecomeapparenttotheowneronlyafterthecar
hasbeendrivenforawhile.
Thesellerofausedcarknowsfromexperiencewhetherthecar
isalemon.
Weassumethatthesellercannotalterthequalityoftheused
car.
 Lemons Market with Fixed Quality
Supposethattherearemanypotentialbuyersforusedcars.
Allarewillingtopay$1000foralemonand$2000foragood
usedcar.
1000ownersoflemonsand1000ownersofgoodcarsarewilling
tosell.
Thereservationpriceofownersoflemons,thelowestpriceat
whichtheywillselltheircars,is$750.
Thereservationpriceofownersofhighqualityusedcarsisv,
whichislessthan$2000.
Markets for Lemons and Good Cars

(a) Market for lemons (b) Market for good cars

Price of a lemon, $

Price of a good car, $

SL
E
2000 DG

1750
f S2 F
1500 D* 1500 D*

1250
e S1
1000 DL
750

0 1000 0 1000
Lemons per year Good cars per year
How Ignorance About Quality Drives
Out High-Quality Goods
Ifbothsellersandbuyersknowthequalityofallusedcarsbefore
anysalesoccur:
allthecars,lemonsandgood,aresold
goodcarssellforahigherpricethanlemons
Thismarketisefficientbecausethegoodsgotothepeoplewho
valuethemthemost.
Ifbothsellersandbuyersareequallyignorantofthequalityofall
usedcarsbeforeanysalesoccur:
Buyershaveanequalchanceofbuyingalemonorgoodcar.
Theexpectedvalueofausedcar=$1500.
Riskneutralsellersplaceanexpectedvalueof:0.5x($750+$v)
Ifv=$1250,expectedvalue=$1000>$1500,allused
cargetsold.
Ifv=$1750,expectedvalue=$1250>$1500,allused
carsgetsold.
Thismarketisefficientbecausethecarsgotopeoplewhovalue
themmorethantheiroriginalowners.

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Ifsellersareabletovarythequalityoftheirproducts,butbuyers
cantidentifyhighqualitygoodsbeforetheypurchase:
buyerspaythesamepriceforallgoods(regardlessofquality),
$1500.Ifv=$1250,allcarssold;Ifv=$1750,onlylemoncars
aresoldat$750.
sellersofhighqualitygoodsdonotcapturethebenefitsfrom
raisingthequalityoftheirproduct.
theincentivetoproducehighqualityisreducedoreliminated.
thesocialvalueofraisingproductqualityisgreaterthanthe
privatevalue.

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How Ignorance About Quality Drives
Out High-Quality Goods
Howmightweavoidproblemsstemmingfromconsumerignorance?
1. Lawstopreventopportunism,likeproductliabilitylaws,may
protectconsumers.
2. Consumerscanobtainreliableinformationaboutquality
throughscreening.
3. Someorganizationspublishexpertthirdpartycomparisons of
brands(e.g.ConsumerReports)
4. Government,consumergroups,orindustrygroupscanprovide
informationbasedonstandardsandcertification.
5. Producersofhighqualitygoodscanusesignaling toinform
consumersabouttheirproductssuperiorityoverrivals.
E.g.,obtain&disseminateindependentcertification.
ContractTheory
Principalagentproblem
Productionefficiencye.g,isafinancialplannerresearchingenough?
Tradeoffbetweenefficiencyinproductionandinrisk
bearingdoestheagenthaveskininthegame?
Paymentslinkedtoproductionorprofitpromoteeffort
Monitoringdetershirkingbyagent
Checksonprincipalsrestrainopportunismtowardsemployees
Contractchoicebadworkersmayoutthemselvesviatheircontract
choices.
 Principal-Agent Problem:
An Illustration of the Problem
Theprincipal (owner),Paul,ownssomeproperty(suchasafirm)or
hasapropertyright(suchastherighttosuefordamagesfroman
injury).
Paulhiresorcontractswithanagent(manager),Amy,totakesome
actionathatincreasesthevalueofhispropertyorthatproduces
profit,,fromusinghisproperty.
IfPaulhiresAmytorunhisicecreamshop,AmyneedsPaulsshop
andPaulneedsAmyseffortstosellicecream.
Theprofitfromtheicecreamsold,,dependsonthenumberof
hours,a,thatAmyworks.
Theprofitmayalsodependontheoutcomeof,whichrepresents
thestateofnature[e.g.,icecreammachinebreaksdown]
=(a,)
 Types of Contracts
Fixedfeecontract :thepaymenttotheagent,F,isindependentofthe
agentsactions,a,thestateofnature,,ortheoutcome,.
Theprincipalkeepstheresidualprofit,(a,)F.[E.g.,rent]
Hirecontract: thepaymenttotheagentdependsontheagents
actionsastheyareobservedbytheprincipal.
Itsthemostcommonbasisofemploymentrelations.
Twocommontypesofhirecontractspayemployees:anhourlyrate
andapiecerate.
Contingentcontract:thepayofftoeachpersondependsonthestate
ofnature,whichmaynotbeknowntothepartiesatthetimethey
writethecontract (eg.thethesplitting orsharingcontract the
payofftoeachpersonisafractionofthetotalprofit).[E.g.fund
managergets2%paofmoneyplacedwithher.]
 Efficiency

Efficientcontract anagreementwithprovisionsthatensuresthat
nopartycanbemadebetteroffwithoutharmingtheotherparty.

Twodimensionsofefficiency:

Efficiencyinproduction situationinwhichtheprincipalsand
agentscombinedvalue(profits,payoffs),,ismaximized.(likethe
outcomeofagamewithcooperation).

Efficiency inriskbearing asituationinwhichrisksharingis

optimalinthatthepersonwholeastmindsfacingrisk,therisk
neutralorlessriskaverseperson,bearsmoreoftherisk.
 Efficient Contract
Twoproperties:
thecontractmustprovidealargeenoughpayoffthattheagentis
willingtoparticipate inthecontract
thecontractmustbeincentivecompatible(itprovides
inducementssuchthattheagentwantstoperformtheassigned
taskratherthanengageinopportunisticbehavior)
Paula,theprincipal,ownsastorecalledBuyADuck(locatednearariver)
thatsellswoodcarvingsofducks.
Arthur,theagent,managesthestore.
PaulaandArthursjointprofitis:(a)=R(a)12a
whereR(a)isthesalesrevenuefromsellingacarvings,and12aisthecost
ofthecarvings.
ItcostsArthur$12toobtainandselleachduck,includingtheamounthe
paysalocalcarverandtheopportunityvalueofhistime.
Maximising Joint Profit when (a) Agent s Pro blem
the Agent Gets the Residual

$ per carving
Agents marginal revenue,
24

Profit

e
12 MC
JointprofitmaximizingQ=12 Demand

P=$18 MR

Profit=$72
0 12 24
a, Duck carvings per day
Whichtypesofcontractslead (b) Profits
E

Agents profit, $
toproductionefficiency? 72

, Joint profit

0 12 24
a, Duck carvings per day
 Full Information

1. FixedFeeRentalContract
IfArthurcontractstorentthestorefromPaulaforafixedfee,F,
FixedfeedoesnotaffecttheMC tomaximizehisprofit,he
hastoperformtomaximizethejointprofit Q=12,andP=$18
Arthurearnsaresidualprofitequaltothejointprofitminusthe
fixedrenthepaysPaula,(a)F.
Theamount,a,thatmaximises Arthursprofit,(a)F,also
maximises jointprofit,(a) .
Forexample:IfF=$48,thenArthurs profit, (a) F = $24
The fixed fee rental contract is incentive compatible.
 2.HireContract
PaulacontractstopayArthurforeachcarvinghesells.
Ifshepayshim$12percarving,Arthurjustbreaksevenoneach
saleasArthursMC=$12
Evenifhechoosestoparticipate,hedoesnotsellthejointprofit
maximising numberofcarvingsunlessPaulasuperviseshim.
IfPauladoessupervisehim,sheinstructshimtosell12carvings,
andshegetsallthejointprofitof$72 thiscontractisnot
incentivecompatible notefficient.
SupposenowPaulapaysArthur$14percarving.Shekeepsthe
revenueminuswhatshepaysArthur,$14timesthenumberof
carvings
R(a)14a
BecausePaulasmarginalcost,$14,islarger,shedirectsArthurto
sellfewerthantheoptimalnumberofcarvings Notefficient.
 (a) Agent s Pro blem
3. Revenue Sharing Contract:

$ per carving
Agents marginal revenue,
24
Reduces Agents Efforts
18

IfPaulaandArthurusea 12
e* e
MC

contingentcontractwherebythey MR

sharetherevenue,jointprofitis 3
MR * = MR
notmaximized. 4

0 8 12 24
SupposethatArthurreceivesthree (b) Profits a, Duck carvings per day

quartersoftherevenue,3/4R,and

Agents profit, $
E
72

Paulagetstherest,1/4R. 64 , Joint profit

Arthursprofitmax:MR*=MC Q
=8(e*) profit=$24
AtQ=8,totalprofit=$64 Paula 24
E* 3
R 12a,
4
gets$40. Agent s profit

Arthurhasanincentivetosellata
lowerquantitytomaximizehisown
20-
0 8 12 16 24
a, Duck carvings per day

profit.
19
 4. Profit-Sharing Contract

PaulaandArthurmayinsteaduseacontingentcontractby
whichtheydividetheeconomic profit,.
Iftheycanagreethatthetruemarginalandaveragecostis$12
percarving(whichincludesArthursopportunitycostoftime),
thecontractisincentivecompatiblebecauseArthurwantstosell
theoptimalnumberofcarvings.
Thatis,Arthurcarves12ducksperday.
Why Profit Sharing Is Efficient

IfArthurgetsathird
ofthejointprofit,he
maximizeshisprofit
bymaximizingthe
jointprofit the
contractisefficient.
 Asymmetric Information
Nowsupposethattheprincipal,Paula,haslessinformationthanthe
agent,Arthur:
shecannotobservethenumberofcarvingshesellsortherevenue
duetothisasymmetricinformation,ArthurcanstealfromPaula
withoutherdetectingthetheft,i.e.,theresmoralhazard(doesnt
arisewithfullinformation).
Onlycontractthatresultsinproductionefficiency&nomoral
hazardiswhentheprincipalgetsafixedrent (fixedfeerental
contract) Arthurreceivestheresidualprofit hewantsto
maximizethejointprofitinordertomaximizehisprofit.
Production Efficiency and Moral
Hazard Problems
 Trade-Off Between Efficiency in
Production and in Risk Bearing

Pam,theprincipal,isinjuredinatrafficaccidentandisaplaintiffin
alawsuit,andAllan,theagent,isherlawyer.
Pamfacesuncertaintyduetoriskand toasymmetricinformation.
Thejuryawardattheconclusionofthetrial,(a,),dependson:
a,thenumberofhoursAllanworksbeforethetrial,and
,thestateofnatureduetotheunknownattitudesofthejury.
Pamneverlearnsthejurysattitudes,,soshecannotaccurately
judgeAllanseffortsevenafterthetrial ifshelosesthecase,she
doesnotknowwhethershelostbecauseAllandidnotworkhard(low
a)orbecausethecasewasweakandthejudgewasprejudiced
againsther(bad).
Contracts and Efficiency

HowhardAllanworksdependson:
hisattitudestowardrisk,and
hisknowledgeofthepayoffforhistrialpreparations.
Thebeneficiary oftheextrapayoffthatresultsifAllanworksharder
dependsonhiscontractwithPam.
IfAllanisriskneutralandgetstheentiremarginalbenefitfromany
extrawork,heputsintheoptimalnumberofhoursthatmaximizes
theirexpectedjointpayoff.
Efficiency of Client-Lawyer Contracts