AN INTRODUCTION TO THE ECONOMICS OF INFORMATION INCENTIVES AND CONTRACTS Second Edition Inés Macho Stadler David Pérex-Catil ‘andatedy Rear Wat OXFORDPREFACE ‘The eamomi of informations posbly th area of economic theory that has coved most over the past ifteen years. Developed in paral withthe new ‘conomie of Industria Organieation, its importance and applications have row spectacularly, objective isto study the situations in which agents tempt to overcome thei ignorance about some relevant information by taking decision designed to aequire new information a to avoid some of the cost of thei ignorance When the infomation i asymmetrically ds tributed among agents, these decisions involve the designing of contracts intended to provide incentives andlor to indice the revelation of private "This book consider stutonsin which asymmetric information exsin contractual relationship, that sto a. in which one participant knows some ‘hing that another doesn. We aaieehremportant themes: moral azar, ‘adverse ston and sallng The models in which these themes ae studi “llow sto explain aarge number of economic situations, eventhough we do not analyse all the economic themes elated to information. Our choice is ‘based onthe ides of looking at only few themes bat in enough depth for our readers to acquire acerain independence “The book s organized inthe following way- There are ive chapters, the ast threebeing deste tothe above-mentioned hemes In Chapter2 we present ‘he symmetric information station, the reference model, which serves 38.8 necessary starting-point to understand the effec ofeach of the informational problems that ll. This chapter presents a base model in which the difer- ‘ent problems ar analysed. The homogencous nature ofthis model has the advantage of allowing the ret tbe compared in simple and natural way. ‘The book begins with an introduction, in which the themes tbe studied ae presented together with several examples tht show how te economics of in ormation can be of interest Hess the examples contained in the principal text ach chapter has de tailed application of the models nd ther reals, In these supplement, we resent simple models with lear economic messages rating to interesting, nd current themes (finance insurance, ecology transfer, frm regulation, publisubsiies et) Often. an application sa simplified version ofan article published in ascentifc journal andcan be read quite independent fom thePreface Imai text ofthe chapter This could be wsefal to those who peferto begin each theme with rigorous presented example. Each chapter also contains exercises of varying difcly,n oder that he stadt can beep tak of his eel of leaing a well a srving a comple rent tothe text Exercises of particular difficulty are marked with an asters Tisneer easy to know if the best strategy fom an insractor point of view is toincladetherlutions tothe exercises inthe same tx or not Since te exe ‘drs aeofen non-conventional, we have decided oincude the solutions a ‘the end of the book Finalh,the more formal aspects ofeach hapler ae rele- sated to complementary materal sections "The book designed tobe a one-semester undergraduate course ortobea support tex fora doctorate cours on the subject. For thisreason, we were ws sbletorevtthe temptation tonclude inthe thee central chaptrssetons on ‘vanced themes. These section do not present new model butraherarede signed tobe a reading guide that we hope willbe uel the interested reader aiid that canbe ignored for introductory course. ‘With especttothe eqired background knowledge tobe abeto follow this introductory course on the Economics of Information, students who have done baie courer of maths and micro-conomics should ind no dificlis in falling this book. The text is xref in it treatment ofthe salations wo constrained maximization problems, bu to resolve any doubts onthe theory of maximization we include ashort appendix onthe Kuhn-Tucke method. ACKNOWLEDGMENTS, “This text was born from the lecture notes used during several academic ‘courses at the University of the Basque Country (Eusal Herrko Uniberstate), and atthe Autonomous University of Barelona (Universitat, ‘Autonoma de Barcelona). The commento he students who worked on pre liminary versions of thisbook hve contbuted0itsenrichment. There ‘tin the themes analysed as been the ving force behing the project. The notesbeeame introduc aa Economia del Ijormacin, published by vil Economia in 194, An Inrduction othe Economies of Information basically ‘the English trandaton ofthe Spanish version, wih some min revisions. We regatta to Ariel Economia andi editor Marcelo Covi for their ep and ‘Support and to Oxford University Press and its editor Andrew Shullerforad- ‘ir and encouragement ‘Many colleagues have collaborated inthe provement ofthe nal version. ‘Weewould keto thank Paul de Bl Femando Branco, Antonio Cabrales, ose vi Preface Maras Rocha, Marla Angele de Fos, a lvl Mate Pst Kiss MERI oa Sobel ey red ener veins of the cuper and ge TINS Sitiguerandsugrsions. We want fo cend our acknowl seta eo whonrwe te xadenical indebted profes to aarese ehom we have colored on ferent projets. Amongthe Grae Stier artes nd Roger Guns deserve spec mention “Mwai it acknowledge our debt colleague Rchard Wat who var cnemous lp during te rpuratin ofthe Engl material fo i Tone at wethan he DGICYT no. P9205, and Human Capital and any projects ERBCHIXCT no, 20055 nd 930297 fr franca aid Inde Macho Sar eid Pérecaslo aera Baral Novomter 1985CONTENTS Pre 1. Introduction 1, introduction 1.2, TheElements ofthe Problem 13. Thelnertemporal Development ofthe Relationship and the Reference Bramework 14. Types of Asymmetric Information Problems ALL Moral haa TELE Adverse ston 143, Signaling 2, The Base Model 2.1, Introduction 2.2, Description ofthe Model 2.3, Symmetric Information Contacts 22.1. Theopima payment means 232 Theopimalleedof ort, 3, The Moral Hazard Problem 2. Introduction 5.2, The Moral Hazard Problem 33. The Agent Chooses betwen Two fort Levels 5.4 Soton Using the First Order Approsch ” a 3 2Contents 2.5, ASimple Cas with Continous Ent ° 3.6. Moral Hstard with Hidden Information st 3.7, Some Comments on the Simple Moral Hazard Models st 7. These of formsion = 373. Theses tects contacts se 174. What happens when itis the agent who ols the 3A. Complementary Material Pa 2A. A geomet ation ofthe morta problem 2 SA2, Thepotiem that maybe found when applying the fs order approsch e 3A9, Thermo agent case a 3B, Applications 6 SIL, Incentive for managers “6 532. Fotingcontracts between ounce e 138. Mora bard and eatning in heat arhet a SA. Invoduciono know bow intechnologywanserconacs 75 Emacs ” SC, Advanced Themes w 4. The Adverse Selection Problem a SCL. Optimal pment mechanismsin stations of moral azar thee aga e 302. Onpiationd deign ia liionshipewithecveslagents 92 SC, Moral based wih ever ta 4 SCH Repeated mora hard SC, Reon between several principals andone agent > 441 traduction 103 42. AMode of Adverse Selection 106 443, When Principals Compete for Agents Ww 43.1 Thebenchmark: Smmetrcinfomaton ue 432. Prins cannot iting petty na 444, Adverse Selection with a Cotinoum of Posie Types Po 45. Comment 4 4A. Complementary Material 136 {12 Mean pt norman (rant cotact cep) 48, Applications {BL Compton ive ir compsi ‘82, Anamipssa opin eelngcotocs ‘3, Regain n ast ifomaton ones {SRA Deekion of monopaty proc qulty ries AC. Advanced Themes C1 Ratoni wither gens Actos 4C2 Orinion sgn SC. Repeated arene ton {4C. Malt mor haar and aden {$C Sora prince Signalling 5. tntedsction 5.2. The Value of Private Information and of Signalling 5.3. Education asa Signal 5 The Agents Signal thei Characteristic Ss, Separating egiibvium 542, Foling guru 5.5. The Informational Power of Cont 5.1. Symmeticinfrmation 552. Theagentraninormed st diay of the job S53, Seprsngequibra 536, Comments 453A. Complementary Material SAL Theinutectieriam 5B, Applications SB, Presthat signal qsity 52, Opinallicening contacts when the seer has pete ‘nfrmation ‘83, Debt level asgnal fea farm 209 210 a2 2” 29 x5. Advanced Themes SC. Eula refinements SC2. Cheap atgames 52, Optnal design of mechanisms in sigaing made “Mathematical Appenia:Concavityand Optimization References Solution tthe Bxecies Index Audivonal Execs iv a a INTRODUCTION ‘Summary ‘Taeenmomicfinirmationsontrel on final pec f cca sa ‘nape the eft en the contrac fort hen cpt ban orl re {afomationalavantage ovr the other. Arent carctis the oly ter ‘stngcassare wen he partlpntshaeopposingobjectes Inallouimedeb,one the prcpantsthe principal sal he baraning power Diferent ype of models appear when the informations symmetry aises Weve ‘moral faztrd peblon when the lft aye eis ert conte as been ined There san ederse scion problem when the agent as elvan Privatinformaton borethecontratisiged Pal siullgsituntion ours the the informed party iabeo reve priate infraton via livia baa ‘our beforethe agreement isormalie1.1 Introduction nha happened to sallat one ime or another, while ata profesional office you dont reeive the sevice ou expected: Sometimes thee ae long queues thilethe employees canbe seen happy chatting away toeachother or alking ‘nthe phone to fiends or elatives bout thee personal afr. Often such ‘stuation someone wil comment its obviusthat ther wages dono depend ‘onhow many ents they sere Behind these words inacricsm of thelackof incentives that soften present in certain contractual arrangements such as ‘buenucatclbbour contacts, Tn some contract the central characteristic appears tobe linked othe incasion o exclusion of incentives. In oter ease the mai etre some ‘hing else In fat, the contracts that we can observe in everyay economic ie are extremely varied, nd hence a valid and interesting question to aek ou ‘elves excl which ype of contrat should go with exch prtclr circa: ‘One particular type of contract that weal may have Ben intersted in at ‘onetime or another stat oferedby automebile insurance companis. Motor ar innarane is of two bate types. The cients generally offered a choice between a contract under which the insurance company paysthe entire cost of ‘ny cla, and a much cheaper one called a vluntary excess contac, under ‘which the insurance company ible only for that prt of cisim oer and howe a stipulated amount. Difeenttypesof driver are interested in diferent Types coverage and othe company offers vations ype of polly and ts ‘etch cen choose the contract hat he prefers In other cases the contract has other properties. An agreements offered ‘only to thoee who comply to certain characteristic and the payment offered varies aecordng to thee characteristics For example its usbal oid inthe ‘tations vaca section of the newspaper adverts tothe fect Recent grad ste equied for new poston in lea frm without actualy speciving the ‘egeceepe. It may seem stange that he employe sony interested in a traduate rather than in what subject he qualified a, especially as going ‘through the rituals of university degree does no appear prepara person "The preceding statins are examples of those that wil be studied in this book: We will be interested inthe theory of contracts under asymmetric. fnformation theory tha seals the characteristics of optimal contractsand ‘the variables that influence these characterises, according tothe behaviour‘Introduction: snd information ofthe partes tothe contac. Thi willow ut tackle que ‘ons such a: Should the employees of an ofce be paid» fixed amount, or ‘shoul they receive some part ofthe profits the rm Or why dos an nar {nce company offer several typesof policy one of which har aoluntary exces ‘cause! Or what the sense ofa situations vacant advert in which the ony televant characteristic isbeing a raduate, without any reference to 2 specie subject? The answers to these, and many other questions, depend onthe st ‘ion at hand. Our objectives to identi the characteristics the relationship, specially those relevant tothe distebution of information that may be Important in answering these questions and to analyse the contrac format thatshouldcorespond to cach parila station * Tn thisintrodaction we wll stempt to day some af the most important concepts andto presen the type of stuation that we intend wo analyse To this nde begin by presenting the basic elements ofthe problem, 4.2 The Elements of the Problem Assume a ister elationship in which one party contracts another o carey lout some typeof action of to take some type of decision, We wil refer tothe Contractor asthe principal and the contacte asthe agent? Both principal and gent could be indivi natttions, organizations or decision centes We ‘ould take, ban example, the relationship between the shareholders of frm (Ghepincpal) and therm manager the gen) “The objective ofthe contrac i forthe manager to carry ost actions on ‘pha of the principal. n our previous example, the manage iscontracted 0 run the principals rm. The contract signed by both pate will speci the payment that the principal wil ass on othe agent (ater on we wll consider ‘what these payments wll depend on). We shall assume that tis always the Principal that designs the contac, and then offer it othe agent, who, afer faving studied the terms of th contact, must decide whether or otto signi. ‘The agent wll accept the principal's contract whenever the tity obtained from igreaterthan thei that the agent would gt rom not signing, We gona 90 Lio 89) ep 90 pe so abe 99) sa a Stank ef tae at ma: Srerrernimenmaeiemnlgn pee ina Introduction refer to this ity eve ae reservation utili We do not permit that he agent ‘makes a counter oe tothe principal station which s known as bltral targinng- Hence we are considering suations in which the principal hall {he bargtning power Ii the principal who decides onthe terms of the ‘lationship whe the agent slimied wo the decision of whether or nt totake part ln effect tsar when the principal oflers «contract to an agent itis trith the commen: this iemy propos tke tor esveit’® If the agent decides not og te contac, the relationship doesnot ake plac, thar ending the problem If,on he oer hand the agent does accept the ‘offer, then according tothe terms ofthe agreement, he must arr out the {ctions for which he hasbeen contracted, In the example ofthe relationship between shareholders and manager, the ater must decide the im’ statgy, hich implies a certui effort diet o diferent task nd projects. ‘Uptomows hesitation we are considering hs the following featres: (i) The principal designs the contrat, or set of contracts. that she wll oer totheagent (i) Te agent accepts the contract if he o desires, thats ithe contract guaranices him geste expecied utility han the other opportunites vaable thin, (Gi) The agent caries oot an ation or effort on behalf ofthe principal From thee elements tan be cen that she agent objets rein confit, wth ikose ofthe principal A cost or ones even forthe othe: the wage pid Ibrevenue forthe agent anda cost forthe principal while the effort of the agent favours the principal bat col for the agent. Soon we wil consider the ole font nour models feral, one ofthe fundamental ingredients. te wll discuss exactly what i meant by contract. contract ia eli able promise by both partes, in which theabligtone of exch, forall posible ‘contingencies ae specie. In particu, itinctudes the payment mechanism Under which the agent wile compensated for is effr. Ia very important point hata contract can ony be based on verifiable variables nother words, ‘the ems of the contract can ony depend on variables that canbe checked by anindependent arbitrator since thi guarantees the fulslment ofthe contact ‘Theuseof veiale variable inthe contac allows either ofthe parties to pre Sent case before a cout of aw with proof of breach of contract in order to ‘demand that the contrat be fled How about contracts bated on non 2 thi oe dc st mean https cant coed Th mabe ego ar ut en acne cay woh ‘Tecnu Tella uh psc ata san permet Unmet Sra icin Septet SenaIntroduction verifiable information? In this case itis difclt to rely om an independent {tbitrator (or empl, court of law) to resale any confi that tay ae, Since the arbitrator wil be unable to prove whether what the paris are ale ing true oF not. Therefore, ince al parties know that arbitration is impos Te, they wll have incentives to breach the terme ofthe contract. Is in {antcpation ofthis stuton that neither party wl be prepared to sign sch ontac, since will no be respected and there willbe ao compensation for breach of conte Sofa the very word that would appear to js this bok, information as ‘arly een sed a al Information ie related tothe set of variables that are ‘erifalein a contractual relationship. Inorderto understand exact how this ew aspects brought iat play leu return othe case ofthe shareholders firmand the manager tha they contactThe lationship isesablahed so hat ‘he manages, viahis personal actions and decisions defends the interests ofthe shareholders. Obviously the shareholders would prefer to contact he best ‘manager, ven if this is somewhat more expensive in order to obtain the best. posible results. However, cer theshaeholdersarenotin 2 good postion Evaluate, o contol the decisions ofthe managers of thir firms. This implies ‘that it becomes imposible fr the contract tobe Based on the managers ‘bchaviou.sincethissnotaverifable variable Oa top ofthis thesharehalers donot have peret information regarding the characteristics ofthe manager hated ether onan individualor group behaviour lee Hence also dficlt ‘o establish contractual tras that depend oa craia competence or quality ‘measures ofthe agents. Sch informational advantages give the managers 8 ceraia eewayin order to enhance their wn sity insesd ofthat of theshare holders. "The objective ofthis book sto analyse situation in which contacts con templated under conditions of asymmetric information, tht i, one party knows certain elevant thing of which the other party i ignorant. We will analyse relationship between two individuals or isitutions in hich one of the participants has an informational advantage over the other, and the in vidual objectives are in conic. The reson for ising eymmeti infor tionand confit of interests isbecaef the contacting paris have common interes, then all relevant information will be avtomatcaly reveled, and so nyasymmetryin information becomes irlevant. ‘The theory is divided into thre main themes: moral hazard adverse sl tio and signaling In moral hazard situation, the principal cannot observe ‘he agen’ behaviout actions or decision). In his eae, the soliton inves the internalizing of incentives, via the contact erm. An adverse election Introduction situation appears when, previous to the signing ofthe contact, the agen is ‘Sate of some relevant information of which he principals ignorant. The Solution to tis problem involves offering several akernative contrat andthe {gent choce between there alternatives reveals his private information Finally signaling modes are related to stations in which oe ofthe partis ‘knows some important information, which signalled to the other party via ‘he informed participants behavou Returning to the examples presented earn theintroductiontothschap- ter eventhough it somewhat premature to assume the reader is capable of {dividing them nt the cocrect informational ateory, we do point out that ‘each one correspondsto oneaf the temes discussed inthe previous paragraph {inthe same order n order beter to understand the diferences between {hee themes (aie om the entiation ofthe patcpants),tisconvenient tobe litle more rigorous inthe deintions thereby establishing more exact 1.2 The Intertemporal Development of the Relationship and Reference Framework Most ofthe model tobe andi this book can be presen om inom funeworh wich ms oer an undewandng characteris Swale compar ofthe concuone ected “The fen or benchmark moda hich we tresses tht bathing an peat han the sme norman oot he atop. That te drintpland te agerbae common mation stl evant Tics and vaablen andthe agente crs eile that tipster the pindpal to check that the age leita Thi con stuaion, Preentedn Chapter, points oa the way in which syne nfoemaion ‘Sothefom ofthe contastandothes anche fetter Son nthe reference sation the princpl andthe agen ae inno doubt ast0 wioissigng becomes The rnp eee diferent frm onc o Sh poste pnt ge depending on sits, owed behavior) Sein thee way each ag ype wile dif cnr mat ‘peningon whch principal ofthe conta andthe ala or which hes Sctngeontae Sint pasts ie fare be eons fre obras ous to inode hee variables explicit the ‘Sim ofthecntceIntroduction tis worth wil pointing ot that we donot assume that both parties tothe ‘contractare perfect informed astoall aspects ofthe reaionship (pect and ‘Symmetric information), but rather that both ar inthe sme informational Poston (symmetric but possibly imperfect information) Hence we do not ‘clude the posbility that there are random elements aectng the elation ‘Ship. In order to represent the existence of «random variable, we shal s3y (lowing casi paneer terial thar Nareisdeciing sme ‘hing The order of moves ofthe benchmark game i summarized in Figur I. where N represents Nature, P represents the principal, and Arepresets the oe a eae dogmse Amys Amps Nurmi Feta ‘This representation ofthe game underline the sequently ofthe dc sions. Given this sequntalty.the solution concept that we apply that b= _game perfec equilibria This slution concep requires that at each poi in time cach payer chooses an optimal strategy, given the station which has been reached, nd asuing that al other payers wild likewise la this way, the agent wil fe the effort tat maximins his enectd lity given that he has accepted the contract proposed by the principal: previous to this, and ntcpating his own deci with ead to effort, the agent decides whether ‘rmot wo accep the contact the fst to act the principal, who having cles Tate he fate behaviour of the gent foreach possible contract format offers that format whch maximizes her own expected ili. Ta game structure such as that shown in Figure 1 its es tose tat in ‘contractual relationships there are many reasons to cxpect that one ofthe ‘ari may hve more information than the other stove leant pect of the relationship. However different situations ae characterized by diferent sources of forms of informational asymmetries. The coreect classification of ‘symmetric information problems is important since t permite the ‘dentifcation of the infisenceof the nate ofthe dstribition of information fon the contract format or on other aspects ofthe reationship ‘shone megs Te oop 114 Types of Asymmetric Information Problems ‘We shall no present the different charactriaic ofthe asymmetric informa- tion problems which we willbe discussing throughout the book. 14.1 Moral hazard Amora harard problem exists when theageacton eno verifiable or when the agent reeves private information fete relationship has een nite. In ‘moral hazard problems the participants hve the same information when the ‘eltionshp is ertablished and the informational asymmetry arises fom the {act that once the contract has ben signed the principal cannot observe (ot cannot ver) the action (or the efor) of the agent oF at leas, the principal cannot perfectly conta the action "The casi way of modeling thi typeof sitsaton is to assume tat the agen'sffrt fered after the contacthasbeea signed snot veriiableandso this variable canat be expliciy incudedin the terms ofthe contact. ence ‘he agent’ pay-off cannot depend onthe effort that he ofr, or that he hat been contracted to offer. Theme schedule ofthe ame corresponding to 8 situation af moral hazard in which the agents effort bot verialeis repre ented in igure 12. tort tt Flnigee Ants Apis ue Sh" Seale a? ne Its ery to imagine labour market situations in which, eventhough the workers (the agents) results verfiable—for example the number of units produced orsold—his effort isnot veriable forte principal Consider pub- Tshing frm tat contracts door-to-door slerman to sellenylopaedias The saleaman will accep the contract offered i guaratees im sleet the ste ‘expected uty asthe net best opportunity nthe markt. The esl ofthe ‘eltionship in thi cae the numberof encyclopaedia sold. Although the ‘numberof orders thatthe lesan gets i obviously a erable viable is ffort is extremely dificult wo measure Infact, even the time dedicated to °Introduction selling encyclopaedia x uncontrollable. Hence the publishing frm cannot Tin thesalesmants wage diety to hiseffort This type of problem requires us to rethink the tational framework in ‘which abou (measored in hoor) exchanged fora xed wage Sore labour Iharkts ike the market for encyclopaedia salesmen, donot fonction in the traditional manner. Another example that of aboratry or research centre (the principal) wh contract ateseatcher to work ona certain project It twouldeppen that not optimal fr the laboratory to pay axed wage in ‘achange fora certain numberof hours onthe jb. ts dif for the pin ‘Spal to dtinguith betwoens researcher who thinking about how o ps theproject through anda escacher who thinking about how to organize his ‘wockend fishing trip Is precisely this dicalty in controling effort inputs, together with the inherent uncertainty in any research projec, that generates “ferent typeof labour market problem tat the economics of information cantacle “Taitional examples of moral hazard corresponding o Figure 1.2 come fromthe insurance sector Ieuranc companies wat the policyholder to 10 ‘vod acide: for example driving m2 ae way oe minimizing losses case ‘of problem. However once a person is insured be as an incentive to change hisbehavoury aking less precautions than before ‘Not all oral hazard problems corespond to the time schedule in Figure 1.2 Some problems within this eategory are due to an informational asym ety tha arses when before careying out the effort for which he hasbeen contacted, the agent observes the esl of Nature's decison but the principal ‘doesnot In ther words the uncertainty these for both when the con teuctisgned,batbefore the actual contacted action the agen wil have ome sort of informational advantage by privately observing relevant variable for ‘rample the level of ffort that would be optimal se Figure 13) I sce oe “amen ‘a F913 ‘Thistime schedule corresponds forxampletoa frm that hitesan impor: ‘export agent to represent is product overseas In some case the firm has ile Information on her existing productsn the county the stat ofthemarkes, ‘te These things all are important forthe determination ofthe bes strategy Introduction use to succesflly introduce the new product However although the agent lb doesn't know these things when he ig the contrat he ca eam her ‘ncehe bens o work onthe introdaction ofthe prodvet. The principal my beable to observe the strategy adopted by the agent but will at be able aluate whether or atthe agent's atios with spect tothe product werethe ‘ost convenient given the market characteristic "Thera man other economic stuationsin which amoral hazard problem is present We wll present the benchmark model ofthese problems Chapter analysing the situation of unobservable fot (that it that station ‘represented in Figure 2), which sso ten considered in theliterture# 142 Adverse selection ‘Anadversseleston problem appears when the agent halls private informa- tom before the relationship is beg. In this case the principal can vr the {agent's behaviour, but the optimal decision, or the cost of this decision, ‘ependson the agetstype thats. on certain characteristics the production process of which the agent isthe only informed party When he informational ’symmetryconcers personal characteristic ofthe gent, then the principal Knows thatthe agent could be anyone of several different types betwern which ‘she cannot distinguish, This situation can be modeled by assuming that Nature plas fst choosing the agent’ type (ee Figure 14) Iti game with symmetric information peviouto th signing ofthe contact, I Ass, Aug Nee uty Tes lificult (or atleast ater cost) for an insurance company to know a particule dient stype when organizing coverage In automobile insurance the insurance company snot indfterent between scarf driver anda more ck les driver who i much more likely to suffer an acide, This information ‘would be mos intresting tothe company i oder that diferent contracts beIntroduction fered to each ype of driver charging more per unit of coverage othe more feces individual However, when a individual contracts automobile ins ther the individual shabitor customs (whether or not he travels many hours tnthout rest wheher or othe ea hey drake or ihe enjoys racing against Fistrend) ae unknown othe compan and the ndvidas declarations potbe ery believable Hence we are gansta situation like that represented inFigure 14 “Adverse selection abo crops up in more non-conventional contrets. The nays of optimal relation sa second aeain which the theory that we shall Study can be naturally applied. Clasic regulation theory establishes imple fecommendtions to repuate public monopoles. Bascal, economic efi ‘enc requis thatthe pie ofthe service be equal tits marginal cost and thatthe regulator covers the firs xed cost with a subvention. I'he regu lator is restricted by some sort of budget constraints that he cannot freely et ‘he subventon then the opin policy ito 8 rie equal to average costs in {hefirm I isyery obvious tha these policies aresubjeto important informa tional requirements Fr example they require thatthe regulator fas faar ‘wth te production cot function ass the ver fir. Thsis nota very realitic [upon More convenient th bypothess that the frm setter informed than the regulator as ots cost stractare Now, we ask ourselves, in order ‘esl the informational asymmetry. st enough that the regulator aks the frm to revel the required infomation inorder to fx the adequate price Cor tthich information on marginal costs needed) and the corresponding sub ‘ention (ned cos)? What woul you do ifyouwere the fim? sems evident {hat we would attempt to take advantage ofthe situation, Therefore, the {pnerament shold ake his problem inte account "Asimple model of adverse election presented in Chapters where we pre. sent other stations tat the averse sletion model allows uso sty and Tester understand? 1.43 Signaling This situation ie similar to adverse sclecton (asymmetric information) Hoyeever afer learning hs ype and before signing he contract, the agent an Send signal thats bserved by the principal (se Figure 13). That sto ay, before the principal offers the contract, the agent takes oe sor of decison that may inivence the principals bei about the agent’sidetity, 2 bay ian obs set 90 seh has nso at Introduction Bis sz Fie.ts ‘Thiscoud be the case of a worker whose bites are dificult to measure chen the priacipl is designing the contrac, and othe worker ies to reveal, his peronal characteristics ti ily that we have alasked ourselves some tine or another ast how we can let ithe knowa to ou employer tha we are hard workers or intelgent. Many peoplecarry out certain activites forthe sole purpose ofprovingthattheyaeindeedhardworkingorineligen. For exam Plo, the fact that someone hasbeen able to nish s university degree, even thoughts content may have absolutely nothing todo wth the job at hand is ‘fen considered to be pos when a candidate evaluated, We wl consider the conditions that an activity mt comply within order tat tay efletve- Iybeconsidereda signal ofthat characteriticthat is dsired tobe made known, Informations very important part of firancial markets, Its ery difficult for investors to know the exact state of affairs of firms, the quality oftheir investments the risks they have contracted, ec. Therefore, any decision made bythe directors, for example the debt evel accumulated, s examined and al: ted inthe markt as. signal. The value of the shares is nluenced by these 0 forall i Thismeansthatwe cannot rule out any esl for nygiven flor level, Theiden that there reno etsthat are possible when ‘heagentchoores cerain effort levels and not posible whenhechoosesothes. IF hs were the case the result obtained woud be evidence ofthe agen’ be ‘avin Later (Chapter 3) we wil dies the consequences of thishappeni snd the reasons why we uit out right fom the start wl become cleat "Throughout this chapter we asume thatthe principal an the agent have ‘he sume information concerning the random component that fet the sult Thirmeansthat they both have the same prior distribution overtheset of posible tates of nature, Hence the information they have when the relation Ships established isthe same for ech Since uncertainty exists, we should consider how the participants react to ria. ink preferences ae expressed by thee utility factions We sal se the conarp of expected utter. other words we assume tha the tity Fane tions of the participants ae ofthe von Neumann-Morgenstern type Let's begin withthe principal She isthe contractor she reeves the production (the result, and he must ay the agent fr his parin the lationship. Using B() the ily function representing the principal’ preferences her objective to obtain the greatest possible prot, Formally the principal’ behaviour de pendson the incon: Bunw), whore wrepresensthe payoff made othe agent. We assume this faction to beconcave increasing: B > 0, 8" 0 (where the primes represent respectively, the fis and second derivatives). The concavity ofthe function B() indies thatthe principal is ether risk-neutral or risk-averse. It isalso worth noting thatthe profit fancton does not depen direly om the agen effort (or oa + ea Xeeescoinum mene iy drut ndings “hapa meneame Mala (Beaten eh sol eh an ‘The Base Model the tet of mature) but only on thereof the ak fr which the agent icon trace, ‘On the other and, the agent eecsvesa monetary payoff for his participa tion in the rditionsip, and he supplies an effort which implies some cost © ‘im. Formally we asome thatthe agent tty function i owe ctv separable inthe component (wage or pay-off and effort). The ‘sumption that the agents preferences aze described by an adie separ le fanction implies that hie rik-aersion doesnot vary with the efort he ‘lie. Thitisrerictionon the model we wll ue, butt does not represent {nlmportant los of generality, andit does have the advantage of simpliying the analysis considerably "The agent obtains tlt fom his wage andhe maybe ithe risk-neutral or rik- vere which tosay the uty function tat represents his preferences ‘oncave in the pay-off On the other hand, greater effort means reser die tilt, Wealso assume thatthe marginal disutility of effort isnot decreasing, Formally On) -veeh, 1 (> 0, (w) $0, Ve) >0, (20. From the objective functions ofthe principal and agent, itiseay tose that ‘one ofthe basic ingredient of our models the conflict of interes between them, This confit sd to three lements. ist, while the princi inter stein theres the agents not directly worried about this tpect Secondly, ‘he principal isnot dvety intrested in fort bat the agetissines isco to him, Finally here ithe iden that greater effort makes better result more likely Therefore thet isa conflict between the objectives ofthe participants, and the contracts the means by whch they can be made compatible In tht. vey, the wage w thatthe principal pays the agent compensates him forthe ‘lft thatthe principal demands, thus apart what the principal eros from the elatonship ends up the agents pocket. Tt shouldbe pointed out thats there wee no conic of interes between ‘the principal andthe agent, they would gre on the best suategy’ ad inde endentiyofwhetheror not the principal has more les. the sume informa ‘onasthe age they would pet thistategy into action (ether by delegation, ‘ory using the adequate communication mechanisms)? strap cen es ean hee ee en a re ‘Schorteert athens ete oes pa nd eats pe fered rman sae at nm "ower he na fi peo 1”‘The Base Model [As we have satin the game that we consider, itis he principal that fers theagenta contract the tems of which are notsubjectto bargaining. The only alternatives open othe agent arto accept oto reject, Soul he eet he wll ‘ave ofall bacon the other opportunites that the mart offers him. These ‘other opportunities, by comparison, determine the it fr participation in the contract. The expected ullty that external opportunites offer the agents Called his reservation ui and ie denoted by LS long asthe contract. Slows the agent tocar expected lity not ess than his eervation wtityshe ‘wil acept st this case the participants ae linked together by this legal ‘tion unl expire. we reconsider the example of tx inspector an shop assistant the reservation uility represents che ullty that they can obtain in othe jobs (Gither contracted on se-employed,) ‘One the mosimportantabjectivesof the economics of information sto characterize the optima ntact between the principal and the agent. To do So, we should ponder on what exact are contacts. Acontactisa document ‘hat species the obligationsof the participants and the ransfers that must be made under diferent comtingencies In order for s contract to be valid, both ‘he contingencies and therm nthe contract mute verifiable A variables ‘id tbe verifiable when it value observable and canbe proved before 3 ‘or of law. This means that any reach af the contract can be reported and jidgedby a court. Also, the contrat may be diferent scoring to the charac tert of the agent and th task for which he contracted. Therefor thisin formation, even if it cannot be specifically included inthe contract, i important forts design. nthe example ofthe taxinspeto, the contac that the ax authority ofers him coud be deren according certain characteristics ofthe individual or ofthe job. For example t may depend on the inspector sedvcational evel for ‘xample, Ph.D, masters, or bachelor), or on the conditions in which he must ‘work With respectto therm ofthe contract, they may include information Such a the numberof ax returns inspected the fraud level detected othe taxpayer clams aceepted, In the same way, the contract fora store asstant ‘may depend on his previous experience, his friendliness, ee The wage paid ‘nay ince ued part an avaiable part that would depend for example on Salesmade, or te rypeof product. In both case asumingthatthe effort the agent isverifabl,thiscan also be included in the onto. sere er aren cba anette nar ea a ‘leon heen hte eee pina arta nto ene {incom ream arene hepanenafcberar Tr eeneh hon, Sceesi sti nd Ayn rt pros aan ey ‘eucgarcur pediment arent opm na 2» The Base Model Final with respect tothe duration ofthe contract, general simple models refer toa satiesitation (a single prid)- All he models that we shall study willbe relationships shat are established only once (ones relationships). ‘Weewll mat be considering what ferences would be incorporated the rl Honship were repeated 2.3 Symmetric information contracts ‘We assume that al relevant information i verifiable, The principals problem Isto design a contract that the agent will acceptin situation in which bath have the same information. Real that thereof the relationship is ra dom variable, an thatthe contract can depend of all erable variables. fn this framework, the principal must decide both the effort tat she demands ofthe agent andthe wages [Cth wl be pa according tthe ‘eul. Inorder todo this she most wok out what contest ar acceptable by the agent given the effort demanded, and then choose fom the contracts that achiev thiseffor the cheapest one. This situation is fier an the central ‘question isto dtersine the optimal isk sharing arrangement between the arcipants. Formally the (Pareto) ficient solution isthe solution the al lowing problem (3: Max Ene Bes-wia)) [etvodien oad [ey : st En(ouor)-vezu. “Thisproblem establishes thatthe principal maximizes the surplus that she ob tains rom the relationships under the retriton tat the agent iwiling 03 ‘cept the contract. Ths condition i known the participation condition. a [P) weare assuming thatthe principal an messue the agent’ effort esince thissa verifiable variable Aswehave already pointed out thecontracthastwo ‘components: the effort (verifiable) andthe py-of contingent onthe rest Eventhough it hasbeen established ha the wage thatthe agent receives de pends only on the result w (x) the contract includes a sufficiently large ‘penatyor fine’ forthe agent to decide togve the effort hat wasageed upon » nse crn apr on soe of bc et re outing tnt a aoe aasson acceaae! ‘We could imagine that in the at of reach of contract would bea court ‘of law that must inc ths punishment. Fr thie reason, in what flows we ‘Shall bear in nnd the fact hat nthe contrat the principal can demand con traced effort fromthe agent, without having to worry about the punishment ‘thatthe agent wl sue should he decide to offer some other effort leven ny case, we asume thatthe fine thatthe court nti sicily high 0 be strictly positive: iit were zr, we would have either B'() ‘ora (.)= += which is imposible given our assumptions Hence the paiipation condition binds Inulieytis ety to understand why the solution tothe problem saturates the agent's partipation condition, Imagine that this were aot 0. Then the principal would be paying too much tothe 2 ‘The Base Model agent. From problem [P=] the principal could reduce all the pay-off w(x) in cha ey thatthe agent would ill accept the new contract ands would et greater uty (since shes paying es) ‘A second way to see thatthe prtipation condition mus bind isthe fol lowing Ifthe agent were to receive lity greater than Tom the relatonship, then he would be wing to py o sign the contract. The principal ould de ‘mand his payment from th agent which requvalent toreducinghiewage by thesameamount inal contingencies “To comments are interesting at ths point Fst the above problem corres ponds toa Puetopsimum inthe most sual sens ofthe erm. Weare maxin- Fring the wtlty of one participant under the restriction that the other parcpant ecelvesaeasta gives evel of uty In his respec asinga ality function forthe agen that is additively separable inthe wage and effort is harmless the analysis ies extended to more general functions). Secondly, notethat by varying Uthat part of thesurplsthat he agent ets, we nd the ‘fcent allocation frontier. Therefore, the solution to this problem con Aisional on the vale ofthe parameter Land he validity ofthe method ge: fal: Independently of how the level of Wis ned, problem [P3] gives us the ‘haracterstes ofthe optimal coma 23.1 The optimal payments mechanism \We shall now turn tothe characterise ofthe optimal contrat, found in [Equation (2.1) indieates thatthe optimal diatrsbution of isk implies "that the llowing equation is ati: FD) — cnatant ay TOP) ‘rin other words the ratio of marginal lites ofthe principal and the agent shouldbe constant whatever she final est. Tiss the familie condition ‘quating marginal rates of substitution (tangency between indiference ‘rvs that characterizes Pareto-efficient situations ‘Ween represent the problem graphically when ther are nly two posible resis = and, with, using the Edgeworth Bo diagram The dimen: Sons of the box are theres ofthe wo contingencies that andy In order to draw it we denote w (3) = m and we rewrite condition (22) forthe eo twa res the follwing way «spend on ppb Rea 186)‘The Base Model Beam) WO) a Blym) ww) oa Hence the point is determined by thi condition and the participation con Aton binding Encouw-vo=u. oa Graphically, inthe Edgeworth bax corresponding othe problem that we are ‘considering we draw the principal's ndiference curves (hey ate inreasingin ‘he pir ofthe result hat goes to the principal, or nother words, towards the int O,), and those ofthe agent (that increase towards O,)- The agent spa "eipation condition tranalates nt the fat thatthe only contract that are acepthle to him are those lated on or above the inference curve cortes- ponding to U The solution, give by the condition (2.3) and (2.4), isa the tangency between the agents reservation inierence curve and te inf. sence curve ofthe principal hts furhert from the ogi O, (see Figure 21). This optimal pont bs characterized by the contingent wage scheme tha the rina offers the agent ifthe rest ie and wf ti Notice that. ‘he vertical dance between O, andthe optimal pont, whe the vertical dis tance between this point and Oy, ~ wi, whch sthepiacipa’s profit when ‘he result (and smal fo ‘Note thatthe ines [Oy and [O, represent sre things (the same py coffinboth tates of ate) forthe principal and the agent respectively AScan beseenin Figure 2.1, sheoptil solution requresthepartcpanttosharethe ‘The Base Mode! kif both are rk aver since the optimal points Between he wo cetlnty foe order to better understand the implications of condition (22) inthe gen- ral case with possible rer, we wil consider several posite with spect tothe objective funtion of the partcpants. ‘DMB (.)= constant thats the prinipliik- neutral, he efcency on Aiton (22) requires that (00 (3) = constant forall the agent ik "ers the only posible way in which the marginal utilis two point can be the mime ifthe two pots ate the sume In other word (82 (x) ) (0 (3) reuires that w(x) = 0 (Therefore, athe optimal contact teagan cea pay of tt dpe fe re wa) =) = Wot ‘The optimal distribution ofrsk when the principal tsk neta for her to acep al the isk, completly nsring the agent. The agent recive the ‘wage w® in all contingencies and this wage willy dependon the effort de ‘uanded. Infact we ean calculate the exact wage Payne wom etre) es) Since we know that the participation constrain binds, “The graphical representation ofthe two-resul case when the principals risk-neutral is given ia Figure 22. The principal’ indifference curves are straight linesinthisease,and the rss that she completly ieuresthe agent 1) Ifthe agent is isk-neutal, (= constant, and the principal isk avers, (.) Osten we ate inthe opposite situation, The optimal contract(The Base Model wil regi that (5,~ 0) ) constant forall Using the same reasoning aowe tate true that 0 (ny) = WO) == By 0. Te ‘ricipals profit now independent ofthe res. Consequently, the agent [cept the ik insoring the principal agaist variations in the esl. The ‘pti contract sa the forms wotadex nk 26 ‘We can interpret this as franchise’ contrac: the agent eeps the rest xand path principal ised amount k independent ofthe result norder thatthe Paticipaton constant besturatd, the constant kms satity Enlerig-t=urre) bE nern-u-ve, “Theamount that he prin es athe peor the agen wo hep the eat Micalfeenebeteean the eet pot rom hc act and theaount teyured forthe agent to secp! the lationship. This oneal an also be [Gnspretd the pes yang the iy (ber) fom the principal The {epic repression iar gue 22 Du imerhanging the ost Reprint andthe get ‘Fb the prin and the agent ar rik aves cchone wil edo accept partof he vata ofthe elt Both prtipamts recive apart then of he fans ry how mth ependon the dees of ‘ak vero. is imeresing fo analyse how the dee of rsk-aerson Incest dtbaton ft ik soc ih he re 0 we Alderete wage ith spect to Tin enor totally ore since oot Tamework dct, Hone it dose an sgh so what happens thn’ promt se wore are dose togther and thes Tmwoukl be exachad we considered s continous variable “The Kho Tackr rst onder contin (2.1) can be writen a =H WO) 4AM (44) )=0. Difeeniatng wit respect oes aoP) a? -o fr $2) aut ogtneeuaty Ely) OPE) ov: by substi 2% wecan sonelide that eee Bl aly de Be principals measure of absolute vsk- id the agent’ measure of absolterisk-avesion (re I we denote by version, andy Cal that bth wll in general depend on the eve of income or wel) then ‘he above equation canbe writen as Wf» oe 27 ds th ay Equation 27) indicates how the agent’ wage changes given an improvement inthe esl Since,» 4) © (03) when both parpants are risk averse, the agent only recees part ofthe incrssed resulta increased wage. The sore risk-averse the agent that toy the rete 7th es the rest inluences hs wage. On he other hand, the more rik avers the principal seater, changes in the result corespend to mote important change in the seage ine lr +7) decreasing). The wo imitcases when ne ofthe paricpants frtk-neteal, 1, = Dorr, 0,have been analysed in) and Gi). ‘As equation (2.7) shows the optimal contract can be very complicated. rather atactive, fort simple, contract forma is the set of ln con Wo(x)= e+ bx, ‘We cana the fllowing question: when linear contract optimal In order for sucha contract tobe optimal, must occur that dvd, = bo in other words the increase inthe wage given an nceasein the result must beconstant iis y/ltg 41) constant. However thicondiion sais on very fw acs sions since asia requires that the participants have constant risk ‘version. Thin turn implies thatthe objective fancionsof the agent and the Panepalare respectively u(w)=—kep (ri) and Bix-w) ‘The above statement shows that, even when information i symmetric, 0p- imal eontractsare very rarely based oa inear payment ‘Thenatare ofthe results that weave presented soar in thissecton are well -nowa, and thy stipulate the optimal distribution of risk na relationship. Hoyer we must itis that in oder hat the allocation be Pareto-efcient Jsnecesary thatthe principal has the sare information asthe agent when the ‘erm ofthe contract ar established and that beach of contract by the agent canbe punished Resp (1, [x-w). a‘The Base Mode! 123.2 The optimal level of effort Les riety consider what wil be she efort level chosen by the agent. As we pointed out, the prablem that appears when one attempt to solve [P= isthat ikisnotnecessarly concave wih respect to effort even though the tity func ions ofthe principal andthe agen are well defined (concave). This sbecase thedstrbation of resulsaso depends onthe agent's effort. Therefore unless ‘we add new conditions rented t the datribution fneton of theres con ‘tinal om eff, the expected ity functions may not be concave In what Fellows, order wo attack this problem in the simplest possible way, we hall ‘consider theft two case dictum the section on optimal contract since Forthese cass we can epic ole for theconeat. (Gi) First assume thatthe principal isrisk-netral( (.) = constant) andthe agentsrsk-averse.Inthiscase weknow fom (2.5), that the optimal contract. iss age that docs not vary with the el w= (+(e) but does de pendon he effort demanded ofthe agent. Hence wecan rewrite the principals problem as: “This problem solved with an optima effort of e Since weare not sure that it iconcaveinthe variable effort we an onl sate that the first-order eandiion [sa neces condition for an interior maximurn. In particle ifthe oil fort level isinterog the t most be tru that Entersetery were, an tthe optimal fot ee, the expected profits ofan increase fot hat 1s pe) xcoincde with he margnalincreaseinthe wage thatthe pin- cipal must pay the agent to compensate him forthe increased disutility of ‘fort which nexprssedby the right handside of (2.8), Aswastobeexpecte, ‘he optimal effort depends onthe values ofthe results, onthe probabilities of getting cach rst in function ofthe efforts, (andthe agent tity fanetion (wand ve. Tn order to express condition (2.8) mor simply we shall us the inverse function theorem. This theorem sys thatthe derative ofthe inverse equal to the inverse of the derivative (evaluated a the corresponding poind Recalling that w=! (J+ ¥(@) equation (28) canbe writen as ro) ‘The Base Model “Tocacultethe second derivative ofthe above problem with respect to efot, vwemust Darin mind that w dv ye "Ouse deb Fw) BO We 10 weber And that, since vo ew ‘Therefore, the second-order condition whichisnecesary inorder that point that sates (2.8) or equivalent, (29) } is efetivelya local maximums ee oo Cety Ut )¥(e= | __ Enrioraechicwov cnr 218 0 A suc coin cnn itt th tn bese sist equity nice endo ober dota mas inthis maybe rales Tae Lor onso, (2.10) For the casein which the pencil srs etal, tht hee ison one swage forthe agent since itis optimal to completely inst hi, we can draw ‘wodiferent graphs how the optimal effort and, simultaneous he wage) isdeterminedin the space.) The ist graph, shown in Figure 23,300 use e232 er ne i ion bt nih ol ep 2suaity (2.9) together withthe participation condition (24), The optimal ‘Ontract sound atthe intersection of bath curves In Figure 2.3,11(¢ denotes the principals rss profiie, neo= Ep toshencer(o= Lpited “Theother somewhat more natura, way of raping the optimal flor ds sion to go back to problem (P] and draw the participation constraint o tether with the principal’ oro curves sce Figure 2.4). Fig.24 “This graph aio illustrates the second-order condition problem: in oder to draw as we have done the curves) = constant asconcave contours (which ‘sss that when an opr curve istangent othe so-tycurve,then isa maximum), we need additional hypothesis onthe behaviou of prot with respect to effort. Condition (2.10) posible hypothesis to guarantee the concavity ofthe principal so-proft curves. (i) In the casein which the agent is isk-neutal and the principal isk verse have see that the optimal contracts franchise ofthe orm w(x) ei The principal decides the effort evelby maiming her pay-off, which ‘ethevaleofthefirm, inthe sameway that the agent doessoithesignsthisype cof sontract. Therefore the optimal elfor level isthe slution to the problem: Max E pion-vies wot itor condone E preergevien en ‘The Base Model {In words the expected marginal sy-off shouldbe equal tothe marginal cost foretfor tbe optimal In oder for an fot level mining (211 tobe oat maximum, werequiethat Lpreorn-v (oso. em In the same way 3 in (),sficient condition fora global maximum shat thecondition 2, 9 () x0, besatisied forall fart evel In general the anaes ofthe optimal effort is more dificult than the analy ‘is ofthe optimal payment scheme fra given effort level Inthe following, ‘haptrs we wllanaye the effects ofthe asyminetric informatio onthe con tract frmand,on several occasions we wilalo show the consequenesson the ‘fort equted rom dhe agent Exercises [Exercise 1. A principal contracts an aget to cary ou certain task The agents the choice of effort, determine the dstrbution ofthe results, which sein the interval X= [3.5] where isthe worst result and ¥ isthe best The ‘ensity function for the results conditional onthe agents effort is fs 6 ‘Assame that forall xe X forall e/se)> 0 (1) Caeaate the optimal wagefnetion when the principal's objecie func ‘ions 8 (2) andthe agents objective uncon i U (wm «)= uC) (0. (b)Caleulate the optimal wage function he pinipal i is-neutal, (0 Underthesameassumptionss (8) cakulatthe efforts satstyingthe ist ‘order condition and analyse whenthe second-order condition holds Whathap pense dsrbution sflasel~ +e (12)where X= [,1},e¢ (0112 Exercise 2. Consider an individual, ora firm, that has an inital wealth wand «property valued at that sbject oir isk In ode o protect himself ‘psinstthe i che indlvidual ean buy an insurance policy from an insurance ‘company. The company andtheindivdualhave the sume pio asto the prob- bility thataire wll occur Denote this probity by passumedconstantand Independent of the individual effort (alternative t depends onthe nd ‘viduals efforts, but as there i symmetric information the insurance contact ‘an demand thatthe individual exerts the correct effort ietakesthe adequate precautionary measure). The indvival can insure the etre value of the ropertyor only a arto his vale, Callthe amount that he deddes to insurea the‘coverage! and denoeit by 4 The company demands a price for providing ‘overage ofan indemnity of should the property buen down. This price Known asthe premium,and we denoteitbyp. ‘With respect othe objective Function ofthe participants, assume tha the insurance company isk-neuttaland thatthe individuals prelerencesae de sevied bythe ult function ww), (a) What then reservation yn ce? (2) What eres (rable varies) canbe nll in the inwsance con (0) Ifthe inrance company chooses the premium nd the coverage htt cer clelat the opti contrat that would beard ox ia averse teem {What would happen ifthe individ were rine Explin {6} Discs theca woul tke i here wee pert competion be tc iaurance companies inate (0) 1) What woud happen if both the insurance company and he india ‘were iver Show that would ot Be pina othe company com livre the ind Exercise 3. Consider a special case ofthe model analysed in Chapter 2 in hich there are only tw posh results Call them success (8) and fale (P), SInce «x, Denoteby ye the probability of sucess when the agent uses. fort a thatthe probability offal ij py 0) = 19s. (4) Write the optimal contract and the necessary conlton for he optimal «fe level forthe ease wen the principal risk neta andthe agen isk ‘ets, and forth case when the agent isk neutal andthe pineal is Sk () Write thesficien condition (2.10) forthisspecial as, anditerprtit. Exercise 4. Consider firm that has acces to group of N workers. Each ‘worker can either work forthe fim or rerain Unemployed, depending on the numberof jobs offered, All workers are identical. The firm, which sel its rodet ina competitive market as «prodaction fncion x= f(s) where isthe number f worker contracted and eisa random hock The realise long othe set [3.4 Denote pn the probability of observing result when workers rc employed When the abou contract issigned; neither {heworker note frmknow hestateofratureebutexposteverone ows ie(the information syne) “The firm isik-neatral interested only in expected profits: x— mw, where the market price for output hasbeen normalized 01 The workers tility ‘The Base Model faction sf the form w(w) ce with! (> 0,1 (9) <0,and where isthe ffot or input of he agent Assure that ec [0 1, where we interpret e= 036 ‘ot working atl (only poser heremaisuneroplojed),ande™ Las work Inge notmal day. Internedate effort eels are led oot We assume hat work ia verflleyaribl, and so fa worker receives a offer a wage whe must ‘hoote between two possibilities either work fr the im, which gies tity tof s(w)~ or remain unemployed, which gives ality fu 3), where 38 the {inemployment benefit pid by the government We a ell (3) = U ( Calelate the optimal contingent wage in funtion ofthe employment lev () The theory ofimplicit contraction ofen used to analyse the labour markt with the intention tory to explain abserved wage riglity and changes ‘employment evel. The theory is based onthe ide thatthe labour market tas particule characteristics that make casa theory (equim between supplyand demand) inadequate, The dais that fizms and workers have con tracts that are more o ess durable, since there is more than jst «purchase involved (pay a wage fora given labour input). A labor contract i aso an insurance contrac, nthe sense thatthe ret ofthe labour relationship are ‘random, and frm generally insure tht workers gains such Hactotions the eesults Tn this way, the wage not necessary equal to the marginal pr: ‘ductivity each state Comment on these ideas given the rest of pa {Calculate the optimal level ofemploymentndanalysehow itvaris with the unemployment benefitTHE MORAL HAZARD PROBLEM Summary ‘Thischpteranarethe moral hazard model The mode dis thse suations in sich the sents behavior snot erable vain the relation. Therefore, ‘cant nlite ter a contact and testers of yest po posed thesymnetrcinormaton modal arm loner adequate ‘The analysis of he moral haar model has wo simple impos First our a tenon ected heft hat when contact fered, ti ec) ake Int acount he decane (the el) tht he ther pry wl ake fhe ace the ‘atop. Theat that there decison caanetbe contd pis sn inpertant ‘cen las nditalsoffectsthe ype of ontractat wl besigned ad he dec sont willbe taken, Secondly the alisha tha the epimal contacts de- ‘Weshow thatforthe contacto infec th behaviour ofthe accepting pasty hes itmus payhim more when the ress rea good signa (he inform) that his e- “Sronwartherequredone Theincentverof the apen mt be inked aja how in ‘ormativ th renltsthat the dion ken the fot caer) was that wich the Principal wanted. 35‘The Moral Hazard Problem 3.1 Introduction In Chapter2 we studied simplereaionship between two parscpants based ‘on one the principal contacting the other, the agent to exert an elo oF tO take some sort of decision, in exchange fora monetary payment. We analysed ‘he reference station in which both participants have the same information, ‘th respect othe variables nd functions determining the relationship (such 2 the production function, or the distribution of the random variable, and ‘ith eect to identities (both know the tity function af the other) and be haviour the relevant decisions of the artiipantsare observable) However t ‘easy to think of uations in which the information of the parties toa con tracts not symmetric tis ao easy to imagine hat the party who has i= Formatonal advantage wl iy tous it to his benefit Inthe chapter we il concenrateonacetain typeof informational asym ‘metry ving odo with the behaviour ofthe agen ring the lationship. As ‘of now, me hall asume that the ain behaviour it notobsreable bythe Principal onifitisobaervable bythe principal tis notverfibl(foraconrt of low). This asymmetric information problem is known 38 moral heard We shall continue to assume that all ther ingredient of the problem are sy ‘metic information. That ff isnot verifiable means that t cor be in- led in thee of the contract since it were, incase of reach of entra, ‘no court of law could know ifthe contract had ely been breached or ol, ‘et us consider afew examples that describe the ype of situation that we ‘want to analyse In labour contract tiscommon tht the effort (ora part of theeffort) a the workers isnot veriable arable. these cases the contract ‘cannot include clauses ofthe ype if see tat you have exerted aot of effort then your wage wll be greater than if you slack: since tis very dif, ifnot Impose, or the firm to prove that the worker has inded lacked Inthe ‘ame ea thelevel of investment of ems specie project isa very dficlt Variable to quantify and soa government that regulates these fms wll, on ‘many ezaion. not be abet this information when tsabihes the op- mal regulation policy. It i lo ery elt for an insurance company 10 serve ust how carefl a cleat as been in oder o avoid accidents and neither the coverage nor the premium can depend on this information. en though the agents effort isnot veriale and so cannot be wed 3 contacted variable, we ssume that the result of thi effor i veriable at the dof the petiod. Consequently, the result obtained wil be included inthe contact that stpultes the agent's pay of the above examples his means ”The Moral Hazard Problem that worker’ wage ill depend on the ales rte production achieved, that ‘heamount the government pay regulated frm could depend onitsalesor its profit or the terms of an insurance contact my pend on the umber ‘ndimportanceof the aceldets tha the int sues "The general scheme ofthe game that we wll be analysing isshown in Figure 3.1, Chronological in the irt place the principal decides what contract to fer the agent. Then the agent decides whether ge not to accep the ration. ‘hip, acoeding tothe terms of the contact established by the principal "nally. thecontracthas been accepted the agent mus decide the efor evel that he mos desires, given the contrat that he hs signed. This ia ree dec sony the agent sinc fot snot contacted variable Hence, when she de Signs the conzact that defines the relationship, the principal must bear in ‘mind that, after signing the contract, the agent wll choose the effort eve that Jsthebest form personal tol tt LD = acne a Inordero understand the nature of the problem facing the principal, con sider what would happen if she proposes the ficient contac (the soltion foundin Chapter 2) when the agent’ ello snot a contracted variable. Cn sider the ae of sk-eutral principal and re-verse agent. Real ha in {Bis ase, the symmetric information optimal contac is forthe principal © completly insure the agent. However, ifthe agent effort is not observable, ‘once he as signed the contact he will eet the effort level thats most beneficial for ime Since the wages independent ofthe result the agent ‘na station in which his wage does not depend on his effort, and oe will we the lowest possible effort. Consequenty the principal wll obtain lower ‘expected profit than that corresponding tothe symmetric information sits tion since the agents fot diferent (ess than) the ecent lve, ‘Wath a contract based ona fied wage, the agents haviour wil always be ‘thesame: he wl choose the smallest posible efor. The principal willantkip atethisresction, and of he proposes acontact based on a fed payoff, she tl chow the wage that eral compensate the agent forthe effort he uses, ‘Therefore the wage willbe wit as dened by ‘The Moral Hazard Problem A =e Ys (20), where Ashe smallest possible fort sitimpossbleo achiev greater effort than eV under contrat that com plete the agent. However the principal can make the gent interested’ Inthe consequence of hisbchaviour by makinghis payoff dependon there sult obtained. In order to understand how this works, consider the follow: ing: insite ofthe principal skneutality and the agent’ rike-aversion, 4 fRanchib-type contract ssgned under which the agent buys the production fom the principal In this case the principal receives fed payment andthe parcpant who acceptrallthe risk isthe agent Ovo the agente now n= terested nthe rel However given the diferences inthe objective fonctions, eis not interested in the result in the same way asthe principal Besides, the franchise contract was alo a posbly in the symmetric information case If ‘he principal di not ue this contract ormat, twas beaut the agent does nat nf tang rss and he isnot prepared to pay to much oaeept thes involved This is why the franchise snot eficint.A franchise ives the agent incentives although perhaps not the best ones) butt ver igh cost en if a franchise does not appest wo be the bes solution to our current problem i doesmake one ofthe characteristics of moral hazard modes cather evident the tradeoff beeen fcc, inthe sense ofthe optimal distrib ‘on ori and incentives This trade of iwhat is defined bythe optimal con. ‘eatin thisype of situation. Throughout thichaper we wile intersted in ‘tying the characteristics ofthis optimal contract. 3.2 The Moral Hazard Problem noo hopin na con wei tattered oe ton ‘Snap cpu a a ce os Surman ip ct che ein te Cine cnn arate pcp sc oa mateo habit pee eben \ remain ee sate ga nee a Sena eee ceaee acme Seyrtieerentcsinhepploeatte pate pee 39‘The Moral Hazard Problem toexert Theda sto slethe game shown in igure 3.1Thenataral solution ‘Snerp subgame perfect equibrium. The inal tage ofthe game —and ths isthe fondamentl pont ofthe moral hazard problemi that in which the ‘gent choose the effort he will zt This choiee ean be writen a cewani| Ercauiwts)-00} on “his condition what we sal ll the incentive resto or the nentve ompatibily constaint This estriton reflects the moral hazard ‘nce the contact hasbeen aceptd and sine effort ino verifiable (tis pot Incladed nthe terms ofthe contrat, the agent wl choose that evel of effort that maximizes his objective faction, Inthe second sage ofthe game, given the effort that he wll exert and the contract terms the agent decides whether or otto acepthe contact thatthe ringpa is proposing Formally, E poruiw(a))-v(oe2w. 0 ‘We shall refer to thi etition asthe participation constant or the individ al atonlty condition, and it was preset in the synmetic information ‘amework Equation (3.2) reflects the fact thatthe agent can aay reject the Contac if what he gets by signing tno at east equal o what he can obain fromthe alternatives inthe market Inthe rst stage ofthe game the principal designs the contract anticipating ‘the agent's behaviour, Formal. the contact thatthe principal proposes the soltion to the allowing problem: Max Ep(e)Boy-wla)) Letts i ey ae Epfouiwiay )-vd2u, oa cea {Epon )-veoh on whee the firs restriction i the participation constraint (3.2) andthe second the incentive compatibility constrain (3.1 ‘When the agent an choose between afinte,but large, numberof fort ev= elsor whe effort i continuo arable thi problem is dificult anase ‘nd posts solution problems. We wil consider thee problems ater on. Fis tre lok a the conclusions we get ina simple framework that easier alge. “The Moral Hazard Problem 33 2. The Agent Chooses between Two Effort Level Many ofthe conclusions of more general models canbe obtained by studying the problem in which the agent can choose between ony two poste efor levels high (H) 2nd low (1). Thiscase xy to analy We shall assume ‘hatte principals isk-neatra This hypothesis simplifies the analysis and, ove all allows uo determine the fle hat the asymmetric information baton the form ofthe optimal contest since under symmetric information the optimal contract isa fixed payment to the agent. Ay deviation from this contractual form is det the existence ofthe moral azar probe. “The oter case hati eany to solve isha in which the agent sk nt However thi situation isnot interesting sine a franchise, that sto the same contact asin symmeticinformation solves the problem Thiscae docs notalow uso se how information inflenesthe optimal contrat, ince the ‘symmetry in thi station inafensine® Consequent we concenrateon 3 relationship involving risk-avers agen. ‘We assume that effort can only take two posible values ¢ ee. The level efrepreent the situation in which the agent works hard, wile exerting «sean that hes being ay or slacking, Natural the dst of effort fresterwhen the agent works hard than for alany agents v(e) > ve). ln the Interest of imply, we order the set of resale X fom worst to est 5, < <_< Let p= pe bethe probability that theres willbe when the agentoffetshigh fort forall ic (1,2...) Inthesame way, we denoteby P= pe) the probability that theres willbe when the agent offers low effort We assume that for al rests these probable are geate than 220 Finale principal prefers high fot alow: One casein which productivity isgreter given igh effort than given low eft is when pst order stocha. ‘aly dominates thas, EatcE nh tral k This inequality represent this fact that bad ests re mote ly when the agent slay than when he works hard Orin other words its ease tat the "esl ester than (foray ken when effort is igh than when ti ow, isobviouly ue that,"The Moral Hazard Problem tis easy to understand tha, the piacpal demands low effort, hen 90 teuemoral hazard problem exits Its enough o pay the agen axed amount, ‘he sme that he would be pad under symmetric information in onde izarantee him his reservation uty evel, and the agen wl choose oo see this mot that given fixed pay-off, the agent wl alway choot he minim effort evel since this wil maximize his uty (minimizes dusty of fort, Therefore, the optimal contact under symmetric information fore, hich was to offer the agent the fixed wage w=! (U+ (€)satistes the Incentive compatibtyonstrunt only ifthe principal indeed demandsthe ef. fortes ot) 2). “The symmetric information contact continues tobe optimal in thi case "The problem becomes interesting i Uh principal demands (which wl beth ese when the good results ate very trative or nother words when is large for large )-As we have pointed out earl, ny fixed payment even that which optinal under synmeti information fre wil only gt the ‘agent to choos In de thatthe agent chooses ewe ned to search fora ‘ntact under which his pay-off depends onthe final esl achieved In this ‘iethe nentve compatiblity constraints writen a follows: Pitaloe(a) )— (092 peut) Hl, which amb writen Eto pel ucts) ) 2 v0 —v(e. 6s) ‘Condition (3.3) has avery intuitive interpretation. The agent wil choose ef fort eel ef the expected tty gain associated wih this efforts preater ‘han the implied increase in cos (sti). In order to calculate the optimal contact under which the agent chooses high effort the principal must sore the following problem ox Sprig 00) xMhie, ns * psy se Eppudwts) )-veen2w 6a) Supninerpiaverne. 09 ‘The Moral Hazard Problem ‘We now search forthe contracts tht ate candidates for the slain wo prob Jem [thats those points that ais che Kaho Tucker conditions of the problem, The Lagrangeanof the system i: Lata d= Spe mts oS paten?-oo- sn[Etoe an ecwe-ven ene DifeeniatetheLagrangean with respetto the wage (x forall “Thefis-order conditions are pits Agi ors) + my which educesto, pt Twa) Al W (06s) )= 0, forall = Byam Ppp forall com G5) Summing equation (33) rom nd bearing mind hat EA pMeE Dg hve a wei Sot, ; Feet 7? a (oe should point out that, in spite ofthe incentive constraint not being concave funtion in wages the solution of the fistorder conditions is ‘maximam)+ Therefore, the Kuhn-Tacker condition with respect t0 the ‘apm Enrta-wete maton trate -Aete-aoen Themcnl det apnyn wth rope mie al smin-n way eta nyt hep a tha ade cnn cet ats Traton 83 ttf pss ecm ed de ey ee SERS i i any ae "Hp supe Carne anti SD cnc so ater sco ace gad nat ise Cee be yee ‘Sivoo Unde sana) stone ee hare Searing ie pce ere ‘ ‘Sire sce dont sccm ‘Shtonemedie foneeestahastech trated a‘The Morel Haserd Problem: purcption constant mpi (thet egies 20) ists andwe EXeafown tn th puri contend witha)” The proper of he puma cotton be more coy eb we rennet fintordercontont 9) intbeallowng cto -nen[t-2h] foratietnmt 7 zee #0 FH] . ‘Not that fom hisequton tse osetia then ints tha (woul eto Beconsant oe sym Sc infrmaion ce: Howe this happens eine compay Druin canot besa thee ade gl om we te ‘Bh hand ie sy ote. Besa he eet poited ot TSSpsun wage willl bay thelowest poste forte The Kar Tuker condone mpow tht he muir said with she incentive compaiy const mute none. There Hi Sty postive Te ct that n> 0 he shadow pie ofthe resection Sct psn) measthathc eaten he rl arr probe inpie May postive cost the pica. The pcs poe ae cy {pute when norman on flr aye tam nen she a me Eerdaeston Sines he agenswage vai according othe lt obtained Ina scar the woe wl egret marth tio pi The rete tho quotin te mal wil be the ight han de of he ondton (3.7 tele and cme ule th dooriaor rst incre, whichin tor equestrian The rai 7p" Caled the iho eo inne he peso th hich the fot x Stas tht heeft wo The male theo quent te reer pire and hes hat het se wi Song ote wor redécon ntheiond tran nctenin the roby ti thee war when fc elt serene the ‘geen bere fn want the agen xe ih fot. Think Tnple ofa anion in whic (hin thet fre) the probate, ‘oun etinaeing Secu saeco icone eae Si ASaee ea dey push nor and arene cf Maaoahp Thies tyson ra mrtg epee SSUGEAC Eaton aed en apes ete ‘Sonn ries reine meron “Sfhod sumed the proctor ee theeqantonwoubeuachanged excep forthe sean a ts Namaste “ ‘The Moral Hazard Problem Aepending on the effort of result ae p/"=0.9 and p= 0.0, wil result, has the fllowing probable py" 001 and p!=0 8. Common sens ia ites thatthe principal wants to indace the agent tenet fot othe mus "sociate a premium with the abseration af ands punishment with the baeration of xe the principal being risk-neutral pays the agent according thereat, {soalyto ive im incentives. Hence se must consider finding sn equlibiam between the benefits tom insufing the agent, at inthe efficient soln, and those available rom him having the correct incentive. T satisfy this object nein the contrat she utes the only verifiable variable a soureof informa tion onthe agent behaviour The principal wes theres in his cae wth similar objective to tha of statistical inference. The benef of ntroding the ‘esl inthe contract isthe formation hat it provides onthe agente? “Anexamplemay elpto clan this pont. Astme that no variable levant totheagentsbehaviou are obserableandableto be incaded nthe contrat. ‘The weathers erable bat the agent cannot affect through his efort, and ‘thas no influence on the agent’ perormance, The principal could mike the nt wage contingent onthe resultof the random variable wether. Ie she Irested in doing thst No. By dings the only effec ito make the agent's ‘wage variable but varies according to something thatthe gent, bis be haviour, cannot influence. Therefore this variable hao vale at a meds of ‘ving the agent incentives but rater ony introduces more sk into the el Tionship. Ths increased risk means that the agent will egies higher wage in ‘order to participate andithas no effet whatsoever on his incentives, “This conclusion i altered when the results veriale variable and the weather hs some inloence overt (isthe case of agricultural proce). 18 Spite ofthe fact that the agent’ effort doesnot influence the weather, it oes Provide information onthe result nd so should be taken into acount in the ‘optimal contract. A good harvests generally a muchstronger signal of hight fortfthewenterbibeen ad than when the weather hasbeen eal The op timal payment an agricultural worker who obtainsa good harvest shouldbe greater for bad weather than fo good wenther ‘Afundamental aspect ofthe optimal scheme that the wage shouldnt de- end atallonthe vale that the principal plceson the rest. This ide tothe factthat ths valuation sindependentf the flor exerted and therefore not informatieast efor and does ot sere atan incentive forthe agent, Oa the 4‘The Moral Hazard Problem aver han, se resis valuable at an informative device at the ants ‘viou The oyofarereted ois information and wince nthe ‘ule longasageeter retained wheter fre alway op Tina hat the woe be inrening ithe rel No. or example stetons ‘tin which the principal wantsthe genta chose an effort wow pose ‘Snsquences a's hope ces ors dma fre, Both with eigifent jrobeblty and with a ntermedae real being very Hkh a is cae he {pina ora shoud pay more for lw rests ha or termed one. ‘The contracts objective not the optimal raksarng arrangement bt ratheritiea device to giveincentves "Theneenry condtion or aber resto ge aber wageisthat te dcresingin Insta this clled the monotonous tod quotient ‘rope tchould be pointed ou that iting conden. The hypothe Gl hst-odernochate dominance, 2, p< ps forall 1 Tedoes not guarantee he monotonous iketiood property However {hippest then w(x) incest Formal om condon (37) we obtain: wal which canbe rearranged get me) "Ween take thie value aa reference For the sich that pH P> law have w(x) Before continuing withthe duction on the characteristics ofthe solution 1 moral hazard, we note with espect tothe above arguments tht the rin: cipainfact does notcarry ost satis inferencesineitisshewho effectively hooses the agents fot by svg problem [P:) Hence se wllknow with erainty how the agent wl bebave Ifthe agent wages depend on the resltit, ie because this ste only way to influence his fort, not because the fort, hoe thatthe agent makes once the contract has bee signed isnot pe ‘tab “6 The Moral Hazard Problem 34 Solution Using the First-Order Approach ‘We have sen the characteristics ofthe optimal contract given a moral hazard problem when there re only two pose effort variables As we have note, {aking the agents effort asa continuous variable, for example ee (0,1) isnot «39, Problem [P] would imply a double maximization, which causes many technical dificule since one ofthe restrictions of [Pisa second man Jmization problem: equation (3.1). Thisincentive compat constait ap pears inan unmanageable form. In the ist studies on moral hazard mods, {his problem was overcome by subsitating the maximization problem of the agent bite ret-ordr condition (Holmstdm, 1979. This procedure icaled the frat onde approach: Te iden iso sbstitate etiction (3.1) in probe [P81 forthe equation: Eno monte )-v(e)=0 os) “The problem posed by this method of solving fr the optimal contri is that (8.8) aot vay equivalent othe agents maximization problem (3.1). The reason is tha it sony the necesary condition In general there ae more ‘forts that sty (28) han those that ati (31), sine it need not be con ‘ave problem. Tis isa serous setback since we are not discussing the proper- ‘sof the solution, but ater weareintedvcing thi equation aearesrction in constrained maximization probler, Therefore, we ae allowing ourslee ‘consider too many points, and we could end up choosing one that ot op ‘imal (or more details, see complementary material). ‘When the first-order approach cozy, the maximization problem ofthe rineipalis wx Spasms) Le tween. cad om w Enowwen-mory an Enwuwinr-vane on Lettng.be the muller forthe participation constrain andy be that ofthe incentive compatiblity constraint, the first-order condition of the Lagrangean wth respect tothe wages w(x) tellus that ”‘The Moral Hazard Problem =PAO+% pe) (wt) ) + m0 Owls) ‘hiss the necessary condition that the optimal contract mus satis. We ao now tit thiscondtioniefiient for ancl maximum since the Hess at a point that stisfes this condion is egative dete (he eason why isi arto that developed in note of thi chape) Rewriting the first-order con- Aon, we obtain the equality 1 le) TowGay7*** pce) Equation (39) implies tha, when > 09 hat when theresa el mora hurd problem, the condition of optimal isk shaingassoviatd withthe case ‘of symmetric information snot satisfied. Thatis.the wages willdependon the ‘euftbiained. The dependence of the wages on the esultin turn depends on the form ofthe function (2, (0 ‘Assume tht p/p, eis iereasing with = 1,» Jn this case the righthand sdeo (39) also increases with ands the same mast happen to thle and side, Given the characteristics ofthe uty anti. thisimplies that w is increasing in The condition tha the iklbod quotient iin ‘eising means that a good result signal that, wih igh probability, good “fort was exerted. Os smother words ismore il that when effort high, the ret good. The conclusion the same shat forthe two possible efor Finally comment on the effort thatthe principal demands ofthe agent under the optimal contract. Insite of the at that prober (P™) is generally, hot concave in effort, we Know that a necessary condition thatthe optimal {Mort not satiate ist-order condition of the Larangean with respect, toe Thisconditon is writen a: es) Ente twin) + | Epica wwe (0) (oe have use the fact that when we derive the participation constrain wth reapestt effort the same expression appears as for the incentive compat ity constraint which we know tobe 20). What is interesting about (3.10) i that shows the tade-off Between pris (the term on the let hand side of The Moral Hazard Problem ‘he equality) and cost (the right handside).-Thecosts areasoisted with ow anagents expected wage changes fo gen changes fort and he incentive ompatblty constraint, whose shadow rice given by the melpir Tes go back for moment to the tymmetric information framework, [Equation (28) is inthis ease, he necenary condition of problem (P!]that the optimal efor mast satis In fact had we obtained the necessary condi tion ret from the Lagrangean, the expression would have been (tis cay show that hs tion identi (29). Comparing 1) tnd G1) how that whe under mmc lafrton he ation ‘onsraint determines the optinl efit eve when theta or arr prblemitisthecetimpidby tenet opty constant chat be {mes the most inportant clement dating the fot coe demanded ithe opee ‘Wetec coins fit one apronch int hnyali Incomplementary materi? weilastat apical te poems hat his tethod an pow The wat oi the ble ie fo wor Wit tod in wh the nt pees gure ht te proc el {fined (nthesense hat iti posto spite estore cod without ‘sor ortfind sme ther way oso te probln, The fed con shat introns nh do fio fs