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**Jean-Jacques Laﬀont & David Martimort
**

October 21, 2003

2

EXERCISES

I- ADVERSE SELECTION

Lending with adverse selection

There is a continuum of risk neutral borrowers with no personal wealth and limited

liability. A proportion ν of borrowers (called type 1) have sure projects with return h for

an investment of 1. A proportion 1 −ν of borrowers (called type 2) have (stochastically

independent) projects with return h only with probability θ in (0, 1) and return 0 with

probability 1 − θ, for an investment of 1. If he does not apply for a loan, the borrower

has an outside opportunity utility level of u.

There is a single risk neutral bank available for loans which has a ﬁnancing cost of r.

The bank oﬀers contracts to maximize its expected proﬁt. For simplicity, we assume that

all projects are socially valuable, i.e.,

θh > r + u

1- Explain why there is no loss of generality in considering the menus of contracts

(r

1

, P

1

), (r

2

, P

2

) where P

i

is the probability of obtaining a loan and r

i

is the repayment to

the bank when the investment succeeds if the borrower announces that he is of type i.

2- Write the maximization program of the bank which chooses the menu {(r

1

, P

1

); (r

2

, P

2

)}

to maximize its expected proﬁt under the borrower’s participation and incentive con-

straints (for simplicity assume that if a borrower applies for a loan he loses his outside

opportunity u).

3- Show that the optimal contract entails a non-random allocation of loans (i.e., P

i

is

either 0 or 1, i = 1, 2). Characterize the optimal contract. Discuss its properties.

3

4 EXERCISES

Bundling with Asymmetric Information

We consider a continuum of consumers who have the following independent willing-

nesses to pay for goods 1 and 2 and desire only one unit of each good. For each good, a

consumer has an equal probability of having valuations θ −ε, θ or θ + ε (with θ > ε).

The two goods are sold by a monopolist who has a zero marginal cost for each of them.

1- Determine the optimal pricing policy for each good and the associated revenue. In this

exercise consider only deterministic pricing strategies.

2- Suppose that the monopolist can oﬀer only a bundle of the two goods at a price P

B

.

Determine the optimal P

B

and show conditions under which it raises more revenue than

the optimal single good prices.

3- Show that there exist prices for the bundle of the goods which improve revenue even in

the presence of the optimal single good prices. (Hint: Draw the table of the surpluses that

the diﬀerent types of consumers derive from the optimal single prices with the associated

proﬁts of the monopoly. Exhibit a price for the bundle which attracts some consumers

and makes more revenue from these consumers than the optimal single good prices).

5

Incentives and aid

We consider the problem of the North willing to aid the poor in the South.

The utility function of a representative agent in the North is

V

N

= q

N

+ n

P

v(q

P

), v

> 0, v

< 0

where q

N

is the consumption, n

P

is the number of poor in the South and q

P

is the per

capita consumption of the poor in the South. Each agent of the North has an endowment

of y

N

. The consumption of the poor exerts a positive externality on the rich in the North

who are n

N

in number.

The representative rich of the South has the utility function

U = q

R

+ n

P

θv(q

P

)

where q

R

is his consumption and θ in {θ,

¯

θ} a parameter describing how altruistic the rich

in the South are. There are n

R

rich in the South, each one with an endowment of y

R

.

The preference parameter θ is private information of the rich in the South. Given

that the North must use the rich in the South as an intermediary (because they control

the government) to help the poor we want to study how the incomplete information on θ

aﬀects the optimal level of aid chosen by the North.

1- Suppose ﬁrst that the South lives in autarky and that the poor of the South are only

helped by the rich in the South. We assume that the poor have no endowment.

Determine the optimal level of aid q

A

P

when it is determined by a representative rich

of the South. The corresponding level of utility obtained by the rich will be called the

status quo utility level U

A

(θ). Special case : v(·) = log(·).

2- Suppose ﬁrst that the North knows θ and brings to the South a level of aid n

R

a

to increase the incentives of the rich in the South to help the poor. Show that if a

is unconditional it does not aﬀect the level of aid. Determine the optimal level of aid

when a can be made conditional on the consumption level of the poor q

P

. Special case :

v(·) = log(·)

3- Assume now that the North does not know θ and let ν = Pr(θ =

¯

θ). Determine the

optimal menu of contracts (¯ a, ¯ q

P

); (a, q

P

), specifying aid conditional on the consumption

of the poor, which maximizes the expected utility of the North under the incentive and

participation constraints of the South. Discuss. Special case : v(·) = log(·)

6 EXERCISES

Downsizing a Public Firm

We consider a public ﬁrm which is producing a public good with a continuum of

workers of mass 1. Each worker produces one unit of public good. A mass q in [0, 1] of

workers produces an output q which has social value

S(q), with S

> 0 and S

< 0.

New outside opportunities appear for workers, calling for a downsizing of the public

ﬁrm. Let θ

i

the outside utility level that worker i can obtain. θ

i

can take one of two

positive values {θ,

¯

θ} with Δθ =

¯

θ − θ > 0. These outside opportunities are identically

and independently distributed between workers on {θ,

¯

θ} with ν = Pr(θ

i

= θ) and 1−ν =

Pr(θ

i

=

¯

θ).

A new allocation of labor is characterized by the proportions p (resp. ¯ p) of workers of

type θ (resp.

¯

θ) who remain in the public ﬁrm. Assuming that workers are risk-neutral,

a downsizing mechanism can be viewed as a pair of contracts {(p, t); (¯ p,

¯

t)} specifying for

each announcement θ or

¯

θ, a probability to remain in the public ﬁrm and a payment

(unconditional on remaining or not in the public ﬁrm).

Total production of the public ﬁrm is then q = νp +(1 −ν)¯ p. Let us ﬁrst assume that

the values of outside opportunities are public knowledge. In other words the government

is under complete information. The workers accept to play the downsizing mechanism

if the government pays them, t for type θ,

¯

t for type

¯

θ and satisﬁes their participation

constraints

t + (1 −p)θ ≥ θ, or t ≥ pθ,

¯

t + (1 − ¯ p)

¯

θ ≥

¯

θ, or

¯

t ≥ ¯ p

¯

θ.

If there is a cost 1 + λ of public funds, social welfare is equal to:

S(νp + (1 −ν)¯ p) Social value of the public good

−(1 + λ)(νt + (1 −ν)

¯

t) Social cost of transfers

+ν(t + (1 −p)θ) Welfare of workers.

+(1 −ν)(

¯

t + (1 − ¯ p)

¯

θ)

If λ > 0, the participation constraints are binding and social welfare can be reduced

to

S(νp + (1 −ν)¯ p) −(1 + λ)(νpθ + (1 −ν)¯ p

¯

θ) + νθ + (1 −ν)

¯

θ.

7

The social optimum is then characterized by:

if S

(ν) > (1 + λ)

¯

θ,

S

(ν + (1 −ν)¯ p) = (1 +λ)

¯

θ and p = 1,

if (1 + λ)

¯

θ > S

(ν) > (1 + λ)θ,

p = 1 and ¯ p = 0,

if S

(ν) < (1 + λ)θ,

S

(νp) = (1 +λ)θ and ¯ p = 0.

From now on, we suppose that the values of the outside opportunities are observed by

the workers, and not by the government.

A downsizing mechanism {(p, t); (¯ p,

¯

t)} is incentive compatible if and only if

¯

t + (1 − ¯ p)

¯

θ ≥ t + (1 −p)

¯

θ

t + (1 −p)θ ≥

¯

t + (1 − ¯ p)θ.

It satisﬁes the participation constraint if

¯

t + (1 − ¯ p)

¯

θ ≥

¯

θ

t + (1 −p)θ ≥ θ.

1- Discuss these constraints and show that one condition is redundant with the other

three conditions.

2- We will say that an allocation of labor (p, ¯ p) can be implemented if there exists a

pair of transfers (t,

¯

t) such that the downsizing mechanism {(p, t); (¯ p,

¯

t)} satisﬁes all the

incentive compatibility and participation constraints.

a) Show that (p, ¯ p) can be implemented if and only if p ≥ ¯ p.

b) For any implementable (p, ¯ p), what is the pair of transfers (t,

¯

t) that minimizes the

social cost of transfers?

3- Determine the allocation of labor and the transfers that maximize expected social

welfare. Distinguish three cases according to the value of S

(ν).

4- Is it possible to structure the payments in such a way that each type does not regret

to have participated in the mechanism? (Hint: diﬀerentiate the payments between those

who stay and those who leave)

5- Suppose that workers diﬀer by the quality of their production in the public ﬁrm. A

type

¯

θ worker produces ρ units of public good while a type θ worker still produces one

8 EXERCISES

unit. Characterize the allocation of labor which maximizes expected social welfare when

ρθ >

¯

θ.

9

Labor Contracts

A ﬁrm designs a labor contract for a worker. The utility function of the worker is,

U

A

= u(c) −θl, where c is consumption and l is labor supply, θ in {θ,

¯

θ} is the preference

parameter known to the worker and u(·) in an increasing concave function; θ <

¯

θ. The

proportion of workers with low disutility of eﬀort, θ = θ, is ν. The agent’s optimal choice

must satisfy the budget restriction c ≤ t, where t is the payment he receives from the

ﬁrm. The ﬁrm has the following utility function: U

P

= f(l)−t, where f(l) is a decreasing

returns to scale production function.

1- Assume the ﬁrm knows θ. Characterize the solution to the ﬁrm’s problem which

maximizes its utility function under the participation constraint of the worker. Call this

solution the First-Best solution.

2- Now assume that labor supply is observed by the employer (and is veriﬁable), but

neither U nor θ are observed by him. Show that the First-Best solution is not imple-

mentable. The ﬁrm can now oﬀer menus of contracts: (

¯

t,

¯

l) and (t, l), where (

¯

t,

¯

l) is the

contract chosen by the worker with disutility of eﬀort

¯

θ and (t, l) is the contract for l.

Find the optimal contract. Compare this (Second-Best) solution to the First-Best.

3- Now suppose that the worker with low disutility of eﬀort has an outside opportunity

that gives him a utility level of V . Characterize the ﬁrst-best and second-best (asymmetric

information) solutions in this case. Take into account that the solution will depend on the

size of V . For Δθ =

¯

θ − θ, consider the cases in which

¯

l

SB

Δθ ≥ V (SB = second-best),

¯

l

SB

· Δθ ≤ V ≤ t

∗

Δθ (∗ = ﬁrst-best),

¯

l

∗

Δθ ≤ V ≤ l

∗

Δθ and V ≥ l

∗

Δθ. Which are the

binding constraints in each case and what type of distortion is needed?

10 EXERCISES

Control of a Self-Managed Firm

Consider a ﬁrm that has a production function

y = θl

1/2

,

where l is the number of workers (considered to be a continuous variable: l in R

+

) and

θ > 0 is a productivity parameter known by the ﬁrm. There are ﬁxed costs of production

A. Let p be the price of the good produced competitively by the ﬁrm.

1- Assume that the ﬁrm is managed by the workers and that its objective function is

U

SM

=

py −A

l

.

Determine the optimal size (for workers) of the self-managed ﬁrm.

2- Let w be the competitive wage rate in the rest of the economy, so that w is the

opportunity cost of labor in this economy. What is the optimal allocation of labor? What

happens if w is too large? Why is the size of the self-managed ﬁrm not optimal in general?

3- Assume that the government knows θ. Consider the case in which w is small enough

to justify the presence of a self-managed ﬁrm. Compute the per unit tax τ on the good

produced by the ﬁrm that restores the optimal allocation of labor. Show that we could

also use a lump-sum tax T on the revenue of the self-managed ﬁrm to achieve the same

objective. (Assume that the ﬁrm is of negligible size with respect to the rest of the

economy).

4- Suppose now that the government does not know θ which can take one of two values

θ or

¯

θ with Δθ =

¯

θ −θ > 0. It uses a regulatory mechanism (l(

˜

θ), t(

˜

θ)) which associates

a labor input l(

˜

θ) and a transfer t(

˜

θ) to the ﬁrm’s announcement

˜

θ. The ﬁrm’s objective

is now

U

SM

=

pθ(l(

˜

θ))

1/2

+ t(

˜

θ) −A

l(

˜

θ)

.

Characterize the set of regulatory mechanisms which induce truthful revelation of θ.

Derive the implementability condition on .

5- Assume that ν = Pr(θ = θ). Suppose that the government wishes to maximize the

expectation of

U

G

= pθl

1/2

−wl.

Show that the solution of this problem does not satisfy the implementability condition;

so that the ﬁrst-best is not implementable even if transfers are costless to the government.

11

What is then the optimal regulatory mechanism, when the labor managed ﬁrm has a zero

outside opportunity level of utility?

12 EXERCISES

Information and Incentives

An agent (natural monopoly) produces a quantity q of a good at a variable cost θq

with θ in {θ,

¯

θ}, Δθ =

¯

θ −θ. The principal gets an utility S(q)(S

> 0, S

< 0) from this

production and gives a transfer t to the agent.

The principal’s utility function is V = S(q) − t and the agent’s utility function is

U = t −θq. Furthermore, the agent’s status quo utility payoﬀ is normalized at 0.

1- Characterize the optimal contract of the principal under complete information about

θ.

2- θ is now private information of the agent and ν = Pr(θ = θ). Characterize the

optimal contract of the principal under incomplete information with interim participation

constraints of the agent (suppose here and later that the value of the project is large

enough so that the principal always wants to obtain a positive level of production).

3- Suppose now that the principal has access to the information technology which allows

him to receive a signal σ in {σ, ¯ σ} with

μ = Pr(σ = σ|θ = θ) = Pr(σ = ¯ σ|θ =

¯

θ) ≥

1

2

.

Determine the updated principal’s beliefs about the eﬃciency of the agent, that is

ν = Pr(θ = θ|σ = σ); ¯ ν = Pr(θ = θ|σ = ¯ σ).

Characterize the optimal contract for each σ.

4- Show that an increase of μ corresponds to an improvement of information in the sense

of Blackwell.

5- Show that an increase of μ has two eﬀects on the principal’s expected utility, the

classical eﬀect (that we will call the Blackwell eﬀect) and an eﬀect due to the direct

impact of μ on the expected utility of the principal conditional on σ.

6- Show that nevertheless the expected utility of the principal increases with μ.

13

The Bribing Game

We consider an administration which is supposed to deliver with some ﬁxed delay a

service to the citizens (passport, permits,...). With the normal functioning of the admin-

istration, citizens derive a beneﬁt u

0

which depends on their valuation of time.

With some additional eﬀort the oﬃcial can deliver the service with a shorter delay.

Let us call q the decrease of delay that the oﬃcial can provide at a cost

(q−Q)

2

2

for him

where Q is a constant.

We assume that there is a proportion ν (resp. 1 −ν) of type 1 (resp. type 2) citizens

who derive a beneﬁt from a decrease q of delay equal to θq(

¯

θq). Citizens are willing to

bribe the oﬃcial to decrease of delays.

Characterize the optimal bribing contract that the oﬃcial will oﬀer to the citizens.

14 EXERCISES

Regulation of Pollution

We consider a ﬁrm which has a revenue R, but creates a level of pollution x from

its activities. The damage created by the level of pollution x is D(x) with D

(x) >

0, D

**(x) ≥ 0. The production cost of the ﬁrm is C(x, θ), with C
**

x

< 0, C

xx

> 0 and θ is

a parameter known only to the ﬁrm. θ can take two values {θ,

¯

θ} and ν = Pr(θ = θ) is

common knowledge.

1- The level of pollution x

∗

(θ) corresponding to the complete information optimum is

characterized by

D

(x) + C

x

(x, θ) = 0.

Show that, if the regulator is not obliged to satisfy a participation constraint of the ﬁrm,

he can implement x

∗

(θ) by asking a transfer equal to the cost of damage up to a constant.

2- Suppose now that the ﬁrm can refuse to participate (but in this case has a zero utility

level) and assume that the regulator has (up to a constant) the following objective function

W = −D(x) −(1 + λ)t + t −C(x, θ) (1)

where t is the transfer from the regulator to the ﬁrm and 1 +λ is the opportunity cost of

social funds. When the regulator must satisfy the ﬁrm’s participation constraint

t −C(x, θ) ≥ 0 for all θ,

characterize the decision rule ˆ x(θ), θ in {θ,

¯

θ}, which maximizes W under complete infor-

mation. Compare with question 1.

3- We assume in addition that C

θ

< 0 and C

xθ

< 0. Determine the menu of contracts

(t, x), (

¯

t, ¯ x) which maximizes the expectation of (1) under participation and incentive

constraints of the ﬁrm.

4- Optional. Same problem when θ is distributed according to the distribution F(θ) with

density f(θ) on the interval [θ,

¯

θ] with

d

dθ

1 −F(θ)

f(θ)

< 0, C

xxθ

≥ 0 and C

θθx

≤ 0.

15

Taxation of a Monopoly

We consider a monopoly facing a continuum [0, 1] of consumers. Each consumer is

characterized by his utility function, θ log q + x, where x is his consumption of good 1

(chosen as the numeraire) and q is his consumption of good 2 produced by the monopoly.

The parameter θ can take two values θ or

¯

θ with

¯

θ −θ = 1 and let ν be the common

knowledge proportion of type θ consumers.

Consumers have large resources in good 1, x

∗

, so that their behavior is always char-

acterized by the ﬁrst-order conditions of their optimization programs.

The monopoly has a variable cost function C(q) = cq and must incur a ﬁxed cost K.

1- Explain why the proﬁle of consumption q

∗

(θ), θ in {θ,

¯

θ} which corresponds to an

interior Pareto optimal allocation is the solution of:

max ν [θ log q(θ) + x(θ)] + (1 −ν)

¯

θ log q(

¯

θ) + x(

¯

θ)

,

subject to

νx(θ) + (1 −ν)x(

¯

θ) = ¯ x −c

νq(θ) + (1 −ν)q(

¯

θ)

−K.

Determine q

∗

(θ).

2- Let {(q, t); (¯ q,

¯

t)} the direct revelation mechanism which elicits the parameters θ from

consumers. Characterize the direct revelation mechanisms which are truthful.

3- Write the optimization program of the monopoly when he is constrained to provide a

non negative utility level to each consumer

θ log q(θ) −t(θ) ≥ 0 for θ in {θ,

¯

θ}.

Characterize the truthful direct revelation mechanism which is optimal for the monopoly.

4- The government uses now a linear tax τ on the consumption of good 2 to control the

monopoly. Assuming that the government maximizes a weighted average of consumers’

utility functions (with a weight 1), of the monopoly’s proﬁts (with a weight σ larger than

1) and of taxes (with a weight λ > 0 such that σ ≥ λ), show that the optimal tax is

negative.

5- Optional. Questions 2 and 3 when θ is distributed according to the distribution F(θ)

with positive density f(θ) on the interval [θ,

¯

θ] with

d

dθ

1−F(θ)

f(θ)

**< 0. Consider the special
**

case of a uniform distribution on [2, 3] and c = 1 and obtain the associated nonlinear

price.

16 EXERCISES

Shared Information Goods, Majority Voting and Op-

timal Pricing

We consider a group of three consumers who share or not an information good sold

by a monopolist who has a zero marginal cost.

Let θ

i

q−

q

2

2

−t the utility function of consumer i, i = 1, 2, 3 where q is the quantity of the

good and t the payment. The θ

i

are independently drawn from the uniform distribution

on [1, 2] and private information of the consumers.

1- Assuming ﬁrst that the monopolist can prevent the consumers to share the good, char-

acterize the optimal pricing policy of the monopolist (under the simplifying assumption

that almost all consumers must have a non-zero consumption level).

2- Suppose now that consumers share the good and the payment. Assuming that demand

is determined by the median consumer, characterize the optimal pricing policy of the

monopolist (hint 1: assume that, for the optimal pricing, consumers have single peaked

preferences and check it ex post), (hint 2: the distribution function G(·) of the median of

three independent draws from the distribution F(·) is: G(x) = [F(x)]

2

[3 −2F(x)]).

3- Show that the expected proﬁt of the monopolist is higher when consumers share the

good.

17

Labor Contract with Adverse Selection

We consider a principal-agent relationship in which the principal is an employer and

the agent is a worker.

For a production level y the worker of type θ (θ in {θ,

¯

θ}) suﬀers a disutility of working

equal to

ψ(θy).

In other words, a worker of type θ must work units of labor (with = θy) which

create a disutility of labor ψ(), ψ

(·) > 0, ψ

(·) ≥ 0.

If he receives a compensation t from the employer his net utility is U = t − ψ(θy).

The employer’s utility function is V = y −t.

1- Apply the Revelation Principle and characterize the truthful direct revelation mecha-

nisms.

2- Assume now that ν (resp. (1 −ν)) equals the probability that the worker is of type θ

(resp.

¯

θ). Characterize the optimal contract of an employer who maximizes his expected

utility under the incentive and interim participation constraint of the worker.

18 EXERCISES

II- MORAL HAZARD

Lending with moral hazard

We consider a cashless entrepreneur who wants to borrow and carry out the following

project. With an investment normalized to 1 unit he will get an output of z with prob-

ability

¯

P > 0 if he exerts an eﬀort level of ¯ e and with probability P > 0 (

¯

P > P) if he

exerts no eﬀort, and nothing otherwise. Let ψ the cost of eﬀort ¯ e for the entrepreneur.

Furthermore his status quo utility level is normalized to 0 and Pz < r.

A monopolistic bank with cost of fund r oﬀers a loan of 1 unit for a reimbursement of

z − x when the project is successful, where x is the share of production retained by the

agent.

Determine the optimal loan contract of a bank which maximizes its expected proﬁt

under the incentive and participation constraints of the entrepreneur.

19

Moral Hazard and Monitoring

An entrepreneur who has no cash and no assets wants to ﬁnance a project which

costs I > 0. The project yields R with probability p and 0 with probability 1 − p. This

probability of success depends upon the eﬀort e in {e

H

, e

L

} of the entrepreneur: it is p

H

if eﬀort is high (e

H

) and p

L

if e = e

L

; 1 > p

H

> p

L

= 0. A loan contract speciﬁes a given

payment P if the income is R and 0 if the income is 0.

The entrepreneur enjoys a private beneﬁt B > 0 if eﬀort is low and 0 if eﬀort is high.

There is a competitive loan market and the economy’s rate of interest is equal to 0.

1- Show that the project is ﬁnanced if and only if

p

H

R ≥ B + I (1)

2- Suppose that (1) is not satisﬁed but p

H

R > I. Introduce a monitoring technology.

By spending m > 0, the lender can catch the entrepreneur if the eﬀort is low and reverse

the decision to obtain a high level of eﬀort; in this case the entrepreneur is punished and

receives 0. The lender and the entrepreneur choose simultaneously whether to monitor

and whether to select a high eﬀort level. The expected payoﬀ matrix for this game is

thus:

¯ e e

Monitor p

H

P −m, p

H

(R −P)) (p

H

R −m, 0)

Not monitor (p

H

P, p

H

(R −P)) (0, B)

Assume m < p

H

R < B.

a. Show that the only equilibrium for P < R is in mixed strategies. Find the

equilibrium strategies.

b. Argue that the project is ﬁnanced if and only if:

p

H

R ≥ m + I.

20 EXERCISES

Inducing Information Learning

We consider a principal-agent problem in which the risk-neutral principal wants to

delegate to a cashless risk-neutral agent protected by limited liability, the acquisition of

soft information about the quality of a risky project as well as the decision to engage or

not in the risky project.

There is a safe project which yields 0 to the principal with probability 1. There is also

a risky project. In the absence of information, the risky project yields

¯

S with probability

ν and S with probability 1 −ν. We will assume that ν

¯

S + (1 −ν)S = 0.

By incurring an eﬀort with cost ψ, the agent can learn a signal σ ∈ {σ, ¯ σ} on the

future realization of the risky project.

We will assume that Pr(¯ σ|

¯

S) = Pr(σ|S) = θ, with θ ∈]

1

2

, 1] being interpreted as the

precision of the signal.

1- As a benchmark, suppose that the principal uses the technology for information gath-

ering himself. Show that the project is done only when ¯ σ is observed. Write the condition

under which the learning of information is optimal.

2- Suppose now that the agent decides to adopt or not the risky project. The principal

uses a contract (

¯

t, t, t

0

) to incentivize the agent.

¯

t (resp. t) is the transfer received by the

agent if he chooses the risky project and

¯

S (resp. S) realizes. t

0

is the transfer he receives

if he chooses the safe project. Write the incentive constraints needed to have the risky

project being chosen if and only if ¯ σ is observed.

3- Write the incentive constraint needed to induce the agent to learn information.

4- Find the optimal contract oﬀered to the agent and determine the

¯

t, t

0

and t which

induce information learning.

5- Find the second-best rule followed by the principal.

21

Optimal Contract and Limited Liability

We consider a risk-neutral principal who delegates a task to a risk-neutral agent

protected by limited liability. His eﬀort e is a continuous variable which costs him

ψ(e) (ψ

> 0, ψ

**> 0). The return to the principal ˜ q follows the distribution (F(·|e)
**

with density f(·|e) on [0, ¯ q] such that the MLRP property

∂

∂q

f

e

(q|e)

f(q|e)

> 0

holds. The principal beneﬁts from q − t(q) where t(q) is the transfers he makes to the

agent.

1- Characterize the ﬁrst-best eﬀort.

2- Write the agent’s incentive and participation constraints when e is non observable by

the principal. Use the ﬁrst-order approach.

3- Write the Lagrangian of the principal’s problem and optimize when the transfer t(q)

belongs to [0, q]. Show that the optimal contract involves a cut-oﬀ q

∗

such that t(q) = 0

for q < q

∗

and t(q) = q for q > q

∗

.

22 EXERCISES

The Value of Information under Moral Hazard

We consider the simple model of contracting with limited liability of Section 5.1.2

except that the probability of success writes as

˜

θ + e where

˜

θ is a random variable with

zero mean.

1- Suppose that the agent chooses his eﬀort before knowing the realization of

˜

θ. Compute

the second-best optimal eﬀort e

SB

.

2- Suppose that the agent wants to guarantee a probability of success R, but can ﬁne

tune the choice of his eﬀort as a function of the realized state of nature that he observes.

Show that ψ

> 0 and ψ

**> 0 imply that the second best optimal eﬀort R
**

SB

< e

SB

.

Conclude.

23

Raising Liability Rule

We consider a lender-borrower relationship under moral hazard. The risk-neutral

borrower wants to borrow I from a lender to ﬁnance a project with safe return V . The

project may with probability 1 −e harm a third-party. The amount of safety care e costs

ψ(e) to the borrower with (ψ

> 0, ψ

> 0, ψ

**> 0). The harm has value h. A ﬁnancial
**

contract is a pair (t,

¯

t) where t (resp.

¯

t) is the borrower’s reimbursement to the bank if

there is no (resp. one) environmental damage.

1- Suppose that e is observable. Compute the ﬁrst-best level of safety care and assume

that the project is socially valuable when the interest rate is r.

2- Suppose now that e is not observable. We suppose that the bank is competitive and

that the borrower has suﬃcient liability. Show that the ﬁrst-best is still implementable if

the bank must reimburse h to the third-party in case of an accident.

3- Suppose that the bank must reimburse c < h to the third-party. We denote by w the

initial assets of the borrower. Show that as w diminishes, the ﬁrst-best level of eﬀort can

no longer be implemented.

4- Compute the second-best optimal level of eﬀort maximizing the borrower’s expected

payoﬀ subject to the bank’s zero proﬁt constraint, the borrower’s incentive constraint and

his limited liability constraint.

5- Show that raising the bank’s liability c leads to a lower expected welfare.

6- Show that this result no longer holds when the bank is a monopoly.

24 EXERCISES

Risk-Averse Principal and Moral Hazard

Suppose that a risk-averse principal delegates a task to a risk-neutral agent. With

probability e (resp. 1−e) the outcome is ¯ q (resp. q < ¯ q). The risk-averse principal utility

is v(q −t) where t is the agent’s transfer and v(·) is a CARA von Neumann-Morgenstern

utility function. Eﬀort costs ψ(e) to the agent (ψ

> 0, ψ

> 0).

1- Suppose that e is not observable, compute the optimal contract with a risk-neutral

agent.

2- Suppose that the agent is protected by limited liability. Compute the second-best level

of eﬀort.

3- Analyze the two limiting cases where the principal is inﬁnitely risk-averse and where

he is risk-neutral. Explain your ﬁndings.

25

Poverty, Health Care and Moral Hazard

We consider an economy composed of a continuum [0, 1] of identical agents. The

income of an healthy agent is w. Each agent becomes (independently) sick with probability

π

0

, in which case he has only a survival income of w. Let δ the proportion of sick agents

who beneﬁt from a medical treatment which costs m per capita: then, these agents recover

their normal income w. Finally, the utility function of an healthy agent or of a sick agent

who has received a treatment is u(·) with u

> 0, u

**< 0. The utility function of a sick
**

agent who has not been treated is u

M

(·) with u

M

> 0, u

M

< 0.

1- Let p the insurance premium that only healthy and treated sick agents can pay. We

have potentially three types of agents:

• a proportion 1 −π

0

of healthy agents with utility level u(w −p),

• a proportion δπ

0

of treated sick agents with utility level u(w −p),

• a proportion (1 −δ)π

0

of non treated sick agents with utility level u

M

(w).

Suppose income redistribution and price discrimination of insurance are not possible.

Write thee optimization program of a utilitarian social welfare maximizer who must satisfy

budget balance of the health sector. Write and interpret the ﬁrst order conditions of this

program with respect to δ and p (assume an interior solution). Determine the comparative

statics of the optimal solution with respect to m, w and π

0

. Let W(π

0

, p

∗

(π

0

), δ

∗

(π

0

))

denote optimal social welfare.

2- Suppose now that with a non observable non monetary cost of health care ψ any agent

can decrease his probability of becoming sick from π

0

to π

1

, with Δπ = π

0

−π

1

.

Determine the various regimes obtained when the expected social welfare is maximized

under the budget constraint and the moral hazard constraint that agents ﬁnd valuable to

spend ψ in order to decrease their probability of being sick.

3- We consider now pairs of agents who observe each other’s eﬀort of health care, and we

assume that agents can perfectly coordinate their health care behavior. Assuming now

that everybody is treated, let t

11

the insurance premium of an healthy agent paired with

a healthy agent, t

12

(resp. t

21

) the one paid by a healthy (resp. sick) agent paired with a

sick (resp. healthy) agent and t

22

the one paid by a sick agent paired with a sick agent.

Maximize the expected social welfare of a pair of agents under the incentive constraints

that the pair prefers exerting two eﬀorts of health care rather than zero or one and under

26 EXERCISES

an expected budget balance equation (guess that the local incentive constraint is binding

and that the other incentive constraint is satisﬁed for u(x) =

√

2x). Show that the

solution obtained dominates the solution with individual contracts.

27

Group Lending with Moral Hazard

We consider two entrepreneurs each of whom can carry out a project with the following

characteristics. Investing 1 generates a stochastic output which can take two values, z > 0

or 0. The probability of success (i.e., of getting z) depends in the entrepreneur’s eﬀort, e,

which can take also two values ¯ e > 0 or 0. The probability of success is ¯ p for a high level

of eﬀort ¯ e and p for no eﬀort with ¯ p > p > 0. The disutility of eﬀort is ψ for ¯ e and zero

for e = 0.

Each entrepreneur has no wealth and must borrow to invest. He can only repay his

loan if he succeeds. Denoting by x the entrepreneur’s share of output, his expected utility

is

• ¯ px −ψ if he exerts eﬀort ¯ e,

• px if he exerts no eﬀort.

Funds are supplied by a proﬁt-maximizing bank which has a cost of funds r. We

assume that:

¯ pz −ψ > r > pz.

1- Determine the optimal contract oﬀer to an entrepreneur when there is a single en-

trepreneur.

2- There are now two entrepreneurs who do not observe each other’s eﬀort level. A

group lending contract calls for a payment x when the partner succeeds and y when it

fails. Consider a group lending contract which induces eﬀort of both entrepreneur as a

Nash equilibrium. Show that a group lending contract does not perform better than the

individual contracts considered in question 1.

3- We suppose now that entrepreneur observe each other’s eﬀort level and coordinate

their eﬀort levels. Consider the program of the bank which implements eﬀort by both

entrepreneurs with group lending contracts:

max ¯ p

2

(2z −2x) + ¯ p(1 − ¯ p)(2z −2y) −2r

s.t.

2¯ p

2

x + 2¯ p(1 − ¯ p)y −2ψ ≥ 2p

2

x + 2p(1 −p)y (1)

≥ 2p¯ px + p(1 − ¯ p)y + ¯ p(1 −p)y −ψ (2)

≥ 0, (3)

28 EXERCISES

x ≥ 0, y ≥ 0.

Find the optimal contract. Show that it is better than individual contracts for the

bank. Explain why.

29

Incentives and Discovery

We consider a principal-agent relationship in which a principal delegates to an agent

the search for a resource of unknown magnitude θ over which the principal has property

rights.

The principal’s utility function is u(q) + t with u

> 0, u

< 0, u(0) = 0 and where q

is the quantity of the resource obtained by the principal and t is the monetary payment

made by the agent to the principal for being allowed to search.

The agent’s utility function is u(θ −q) −t.

1- Under complete information about θ, determine the optimal contract oﬀered to the

agent by a principal who maximizes his utility under the participation constraint of the

agent

u(θ −q) −t ≥ 0.

2- θ can take one of two values {θ,

¯

θ} with respective probabilities (1 − ν, ν), with

Δθ =

¯

θ − θ > 0 and is now private information of the agent. Suppose that the prin-

cipal oﬀers a contract to the agent before the agent’s search, i.e., before the agent learns

θ. Characterize the optimal contract that the principal oﬀers to the agent when he maxi-

mizes his expected utility under the agent’s incentive constraints and the agent’s ex ante

participation constraint.

3- We assume now that the contract is imperfectly enforced. When the agent discovers

¯

θ (resp. θ), he can exit the relationship with a quantity Δθ (resp. 0) of the resource.

Therefore, the principal is faced with the following ex post participation constraints:

u(θ −q) −t ≥ 0 (1)

u(

¯

θ − ¯ q) −

¯

t ≥ u(Δθ), (2)

if he wants to maintain both types of agent in the relationship.

Show that the regime with the participation constraint of the “ineﬃcient type” θ, and

the incentive constraint of the “eﬃcient type”

¯

θ cannot be optimal (hint: assume the

contrary).

4- Consider the regime where only the participation constraints (1) and (2) are binding

(i.e. the incentive constraints are slack). Show that this is the relevant regime when

Δθ > θ. Characterize the optimal contract and denote W(ν) the principal’s expected

welfare.

30 EXERCISES

5- We assume now that by exerting an eﬀort which costs him ψ the agent increases the

probability of a

¯

θ-discovery from ν

0

to ν

1

> ν

0

with Δν = ν

1

− ν

0

. Show that W(ν) is

decreasing in ν. Write the program of a principal who selects a contract which discourages

eﬀort. Solve it when u(Δθ) <

ψ

Δν

. Discussion.

31

III- MIXED MODELS

Political Economy of Regulation

We consider a ﬁrm which realizes two projects, of gross value S

1

and S

2

for the

consumers. The ﬁrm can provide an eﬀort e

i

in order to reduce the cost associated with

project i, i = 1, 2. The cost function of the ﬁrm for project i is:

C

i

= β −e

i

where β is the eﬃciency parameter of the ﬁrm. The eﬃciency of the ﬁrm is the same for

both projects.

Parameter β can take values in two values {β,

¯

β} with ν = Pr(β = β).

The cost reducing eﬀorts create a disutility to the ﬁrm equal to

ψ(e

1

, e

2

) =

1

2

(e

2

1

+ e

2

2

) + γe

1

e

2

, γ > 0.

A regulator reimburses the observable costs C

1

and C

2

and pays a net transfer t to

the ﬁrm which has utility

U = t −ψ(e

1

, e

2

).

Social welfare is

S

1

+ S

2

−(1 + λ)(t + C

1

+ C

2

) + U.

1- Determine the optimal regulation under complete information.

2- Determine the optimal regulation under incomplete information when β is private

information of the ﬁrm.

3- We assume now that the regulatory mechanism is determined by the political majority.

Agents are of two types. Either they are stakeholders in the regulated ﬁrm, i.e., they share

the rent of the regulated ﬁrm. Or they are non-stakeholders and do not share the rent.

Let α the proportion of stakeholders. If α > 1/2 the majority belongs to stakeholders

who choose regulation to maximize their objective function:

α(S

1

+ S

2

−(1 + λ)(t

1

+ C

1

+ t

2

+ C

2

)) + U.

32 EXERCISES

If α < 1/2 the majority belongs to non-stakeholders who choose regulation to maximize

instead:

(1 −α)(S

1

+ S

2

−(1 + λ)(t

1

+ C

1

+ t

2

+ C

2

)).

Determine in each case the optimal regulation under incomplete information.

33

Regulation of Quality

We consider a natural monopoly which has the cost function C = (β +s −e)q where q

is the production level, e is the eﬀort level of the manager, s is the quality of the product

and β in {β,

¯

β} is a cost parameter.

We assume that the regulator observes only the cost C and the ﬁrm’s revenue, and, in

addition, pays a transfer t net of cost and revenue. If ψ(e) (with ψ

> 0, ψ

> 0, ψ

≥ 0)

is the disutility of eﬀort for the manager, it implies that the net utility of the manager is

U = t −ψ(e). His outside opportunity utility level is normalized at zero.

We assume that the consumers get a gross surplus from the consumption of q units

equal to

S(q, s, θ) = (A + ks −hθ)q −

B

2

q

2

−

(ks −hθ)

2

2

where A, B, h, k are positive constants and θ in {θ,

¯

θ} is a demand parameter known by

the ﬁrm, but not by the regulator.

Let p(q) the inverse demand function. The utility derived by consumers is then:

V = S(q, s, θ) −p(q)q −(1 + λ)(t + C −p(q)q)

where 1 + λ is the opportunity cost of public funds.

1- We consider a utilitarian regulator who wants to maximize expected social welfare

(V + U). Show that the adverse selection problem with two parameters θ and β can be

reduced to a one dimensional adverse selection problem with the parameter γ = β +

h

k

θ.

2- Assume that γ is distributed according to a uniform distribution. Write the maxi-

mization problem of the regulator under the incentive and participation constraints of the

ﬁrm.

3- Show that the optimal regulation can be implemented with indirect mecanisms which

are functions of a variable which aggregates the cost and quality dimensions.

4- Study the dependence of the optimal regulatory mechanism with respect to the concern

for quality.

34 EXERCISES

Enforcement and Regulation

We consider a natural monopoly which, in addition to a ﬁxed cost F which is common

knowledge, has a variable cost function

C = (β −e)q,

where q is the production level, β is an adverse selection parameter in {β,

¯

β} with ν =

Pr(β = β) and e is a moral hazard variable which decreases cost, but creates to the

manager a disutility ψ(e) with ψ

> 0, ψ

> 0, ψ

≥ 0.

Consumers derive an utility S(q), S

> 0, S

**< 0 from the consumption of the natural
**

monopoly’s good. Let p(·) the inverse demand function and

ˆ

t the transfer to the ﬁrm

from the regulator. The ﬁrm’s net utility is:

U =

ˆ

t + p(q)q −(β −e)q −F −ψ(e).

We assume that cost is ex post observable by the regulator as well as the price and the

quantity. So, we can make the accounting assumption that revenues and cost are incurred

by the regulator, who pays a net transfer t =

ˆ

t + p(q)q −(β −e)q −F. Accordingly, the

participation constraint of the ﬁrm can be written:

U = t −ψ(e) ≥ 0.

To ﬁnance the transfer t, the government must raise taxes with a cost of public funds

1 + λ, λ > 0. Hence, consumers’ net utility is

V = S(q) −p(q)q −(1 + λ)

ˆ

t.

Utilitarian social welfare writes then:

W = U + V = S(q) + λp(q)q −(1 + λ)((β −e)q + F + ψ(e)) −λU.

1- Under complete information, the regulator maximizes social welfare under the ﬁrm’s

participation constraint. Characterize the optimal solution.

2- Suppose now that the regulator cannot observe the eﬀort level e and does not know

β. However, he can oﬀer a contract to the ﬁrm before the latter discovers its type (see

Figure 1 for the timing).

35

E

Time

The regulator

oﬀers the

regulatory contract.

The ﬁrm

accepts or not

the contract.

The ﬁrm

discovers

its type.

Production

and transfer

take place.

Figure 1

Explain why the regulator can restrict his contract to a pair {(t, c); (

¯

t, ¯ c)} (where c =

C

q

is average cost) which satisfy incentive constraints.

Write the incentive constraints and the ﬁrm’s ex ante participation constraint. Solve

for the optimal contracts.

3- We assume now that if the ﬁrm has a negative ex post utility (as ﬁrm

¯

β in question

3) it attempts to renegotiate its regulatory contract. However, with a probability π(c),

the regulator is able to impose the implementation of the agreed upon contract. This

probability depends on the expenses c incurred to set up an enforcement mechanism.

We assume that π(0) = 0, π

> 0, π

< 0 with the Inada conditions π

(0) = ∞ and

lim

c↔+∞

π(c) = 1.

With probability 1 −π(c) the regulator is forced to accept a renegotiation. To model

this renegotiation we use the Nash bargaining solution but assume that renegotiation is

costly (because it takes time say). The status quo payoﬀs which obtain if the negotiation

fails are determined as follows: The ﬁrm loses its ﬁxed cost F. The regulator is also

penalized by a loss of reputation and obtains the utility level −H.

Assume that it is only the ineﬃcient type

¯

β which wants to renegotiate. Therefore,

costly bargaining takes place under complete information. Its outcome solves:

max

{¯ q,¯ e,

¯

U

E

}

(

¯

U

E

+ F)(δ

ˆ

W(¯ q, ¯ e,

¯

β) −λ

¯

U

E

+ H)

where δ in (0, 1) models the cost of renegotiation and

ˆ

W(¯ q, ¯ e,

¯

β) = S(¯ q) + λp(¯ q)¯ q −(1 + λ)((

¯

β − ¯ e)¯ q + F + ψ(¯ e)).

Compute the outcome of renegotiation (¯ q

E

, ¯ e

E

,

¯

U

E

).

4- Write the ﬁrm’s new participation constraint which takes into account that with prob-

ability 1 −π(c) there will be renegotiation.

Substitute the outcome of renegotiation into the regulator’s objective function and

solve for the optimal contract and the optimal level of enforcement expenses c. Discuss.

36 EXERCISES

Regulation of a Risk Averse Firm

We consider a utilitarian regulator who wishes to realize a public project which has

social value S. A single ﬁrm can undertake the project for a cost, C = β −e, where β in

{β,

¯

β} is an eﬃciency parameter and e is a level of eﬀort which creates a disutility ψ(e)

(ψ

> 0, ψ

> 0, ψ

**≥ 0) for the ﬁrm’s manager.
**

The cost C is observed by the regulator who can give a transfer t to the ﬁrm with a

cost of public funds 1 + λ.

The manager of the ﬁrm is risk averse, and has the utility function u(t − ψ(e)) with

u

> 0, u

< 0).

e and β are not observable by the regulator, but it is common knowledge that ν =

Pr(β = β).

1- For the revelation mechanism {t(

¯

β) =

¯

t, C(

¯

β) =

¯

C; t(β) = t, C(β) = C}, write the

incentive and participation constraints of the ﬁrm.

2- Expected social welfare is deﬁned as

W = S −(1 + λ)

ν(t + C) + (1 −ν)(

¯

t +

¯

C)

+ u

−1

(νu(π) + (1 −ν)u(¯ π)) ,

with π = t −ψ(β −C) and ¯ π =

¯

t −ψ(

¯

β −

¯

C).

Interpret this social welfare function and, assuming that it is concave in (π, ¯ π), de-

termine the optimal regulation under incomplete information when the regulator oﬀers a

contract at the interim stage.

3- Compare the result of question 2 with the case where the ﬁrm’s manager is risk neutral.

4- Consider the special case

u(x) =

1

ρ

(1 −e

−ρx

).

Show that the eﬀort level required from type

¯

β is decreasing in ρ.

37

Technological versus Informational Advantage

We consider a project which has value S for consumers. This project can be realized

by two diﬀerent ﬁrms run by two diﬀerent managers.

Firm 1 has the cost function C

1

= β

1

− e

1

where β

1

is an eﬃciency parameter which

is common knowledge and e

1

is the manager’s eﬀort level which creates a disutility

1

4

e

2

1

for him. Ex ante β

1

is unknown for everybody and drawn from {2, 3} with Pr(β

1

= 2) =

Pr(β

1

= 3) = 1/2.

Firm 2 has the cost function C

2

= kβ

2

− e

2

, k ≤ 1, where β

2

is also drawn ex ante

(independently of β

1

) from {2, 3} with Pr(β

2

= 2) = Pr(β

2

= 3) = 1/2. However, the

value of β

2

is only observed by the manager of ﬁrm 2; e

2

is the manager’s eﬀort level

which creates a disutility

1

4

e

2

2

for him.

C

1

and C

2

are observed by the regulator. The outside opportunity utility levels are

normalized to zero for both ﬁrms. The timing of events is summarized below:

E

t

ex ante interim

β

1

observed

by all, β

2

observed by

ﬁrm 2

Regulator

oﬀers

contracts

Firms

accept

or

reject

Contracts

are

executed

The regulator is utilitarian and can use transfers with a price of public funds 1 + λ,

λ > 0.

1- Assuming that the regulator oﬀers a contract only to ﬁrm 1, at the interim stage, what

is the optimal regulation?

2- Assuming that the regulator oﬀers only a contract to ﬁrm 2 at the interim stage, what

is the optimal regulation?

3- Assuming that the regulator selects the ﬁrm at the ex ante stage, characterize the

values of λ and k such that ﬁrm 2 is chosen.

4- Assuming that the regulator selects the ﬁrm at the interim stage, characterize the

values of λ, k and β

1

such that ﬁrm 2 is chosen.

5- Suppose that k can be chosen ex ante at the cost

(1+λ)(3−k)

2

2

by the regulator; what is

the optimal strategy of the regulator at the ex ante stage?

38 EXERCISES

Piracy and Optimal Pricing

We consider a ﬁrm which can buy from a monopoly with marginal cost c software in

quantity q

0

at price p

0

or pirate software in quantity q

c

at a random cost ˜ c which includes

the illegal reproducing cost itself and a random ﬁne. The value for the ﬁrm of these

purchases is

R(q

0

+ αq

c

) with α ∈ [0, 1].

The ﬁrm has a utility function with constant absolute risk aversion so that his utility

is

−e

−ρ[R(q

0

+αqc)−p

0

q

0

−˜ cqc]

.

1- Assuming that ˜ c is a normal random variable with mean μ and variance σ

2

, compute

the demand functions q

0

(p

0

), q

c

(p

0

) of a ﬁrm maximizing its expected utility. What is the

optimal monopoly price p

M

0

? Study the dependence of p

M

0

with respect to ρ, σ

2

, μ, α, c.

Suppose

R(q

0

+ αq

c

) = a(q

0

+ αq

c

) −

1

2

b(q

0

+ αq

c

)

2

.

2- For a social welfare function W which adds proﬁt to the certainty equivalent of the

consumers’ utility level, characterize the (constrained) optimal q

0

and q

c

. Study the

comparative statics of W with respect to α, μ, σ

2

, c (Hint: use the envelop theorem).

Let

˜

W be social welfare under monopoly. Obtain

∂

˜

W

∂μ

. Let μ = c

0

+ f where c

0

is the

reproducing cost and f an expected ﬁne. Supposing that the cost of implementing the

ﬁne f is

1

2

δf

2

, determine the optimal ﬁne.

3- What is the optimal two part tariﬀ of the monopolist?

4- Assume that ρ is private information of the ﬁrm and can take two values ρ or ¯ ρ with

¯ ρ > ρ and ν = Pr(ρ = ρ).

We will look for the optimal nonlinear price or the optimal direct revelation mechanism

(t, q

0

,

¯

t, ¯ q

0

). First show that the Spence-Mirrlees property holds for the surrogate utility

function:

V (t

0

, q

0

, ρ) = max

qc

¸

R(q

0

+ αq

c

) −t

0

−μq

c

−

1

2

ρσ

2

q

2

c

.

Write the ﬁrm’s incentive constraints for the function V . Solve for the optimal direct

revelation mechanism. Discuss.

39

Gathering information before signing a contract

We consider a principal agent problem in which the agent produces a quantity q of a

good at a cost θq with θ in {θ,

¯

θ},

¯

θ > θ. Let t be the transfer from the principal to the

agent ; then, the agent’s utility is U = t −θq.

The principal’s utility is

V = S(q) −t with S

> 0, S

< 0 and S(0) = 0.

At date 1 the principal oﬀers a menu of contracts (t, q), (

¯

t, ¯ q).

At date 2 the agent decides to learn θ at a cost ψ or not. Let e be this decision : e = 1

if he learns, e = 0 if not. e is a moral hazard variable not observed by the principal.

At date 3 he accepts or not the contract.

At date 4 the agent learns θ if he has decided not to learn it at date 2.

At date 5 the contract is executed.

We will consider two sets of contracts : those (class C

1

) which induce the agent to

choose e = 0 and those (class C

2

) which induce the agent to choose e = 1.

1- Write the optimization program of a principal who maximizes his expected utility

under the incentive and participation constraints of the agent, either in the class C

1

or in

the class C

2

of contracts.

2- Show that a lower bound for the principal is obtained by constraining contracts to

t −θq ≥ 0 ;

¯

t −

¯

θ¯ q ≥ 0. Derive from this result that the interesting contracts to consider

entail

¯

t −

¯

θ¯ q ≤ 0. Show that the principal can always mimic a contract in the class C

2

with a contract in the class C

1

.

3- Determine the optimal contract in the class C

1

. (Distinguish three cases depending on

whether the ex ante participation constraint is binding, the moral hazard constraint is

binding or both constraints are binding according to the value of ψ).

40 EXERCISES

Better Information Structures and Incentives

We consider a natural monopoly which realizes a public project valued S at a cost

C = β −e when β in {β,

¯

β} is a parameter which is privately known by the manager with

Δβ =

¯

β −β > 0 and ν = Pr(β = β) is the common knowledge probability that the ﬁrm is

a low cost ﬁrm; e is the manager’s eﬀort which has a disutility ψ(e) with ψ

> 0, ψ

> 0,

ψ

**≥ 0. The cost C is observable by the regulator and reimbursed to the monopoly.
**

Accordingly the ﬁrm’s utility is

U = t −ψ(e)

where t is the net monetary transfer from the regulator to the ﬁrm and consumers’ welfare

is

V = S −(1 + λ)(t + β −e)

where λ > 0 is the social cost of public funds.

Social welfare is deﬁned as U + V .

1- Characterize the regulation which maximizes expected social welfare under the ﬁrm’s

incentive and participation constraints (it is assumed that the regulatory contract is of-

fered to the ﬁrm at the interim stage and that its status quo utility level is zero).

2- The regulator beneﬁts ex ante from an information structure J with a set Σ =

{σ

1

, σ

2

, . . . , σ

I

} of signals and conditional probabilities Pr(σ

i

|β) i = 1, . . . , I. Denote

ˆ ν

i

the posterior belief that the ﬁrm has a low cost after signal σ

i

, i.e., ˆ ν

i

= Pr(β = β|σ

i

),

i = 1, . . . , I.

Characterize for each σ

i

the optimal eﬀort level ¯ e

i

requested from the high cost ﬁrm

and denote ¯ e

i

= Z

ˆ ν

i

1−ˆ ν

i

the solution ¯ e

i

as a function of the ratio

ˆ ν

i

1−ˆ ν

i

.

Show that, if after each σ

i

, the regulator wants to keep both types of ﬁrms, and if Z

is concave, the expected power of incentives decreases when the regulator has access to

the information structure J.

Discuss the more general case where after some signals the regulator may want to shut

down the high cost ﬁrm.

41

Competitive Pressure and Incentives

We consider the case of a monopoly (producing good 1 in quantity q

1

) with a com-

petitive fringe producing a diﬀerentiated good 2 in quantity q

2

. The consumers’ utility

function is

S(q

1

+ q

2

) + θq

1

q

2

where θ is a measure of complementarity of the two goods.

The monopoly’s cost function is

C

1

= (β −e)q

1

,

where β in {β,

¯

β},

¯

β > β, is an adverse selection parameter (with ν = Pr(β = β)) and e

is an eﬀort level which decreases cost with a disutility for the manager of ψ(e), ψ

> 0,

ψ

> 0, ψ

≥ 0.

The fringe’s cost function is

C(q

2

) = cq

2

where c is common knowledge.

Let p

1

(q

1

, q

2

) the inverse demand function of good 1.

1- Show that for a utilitarian social welfare maximizer the social welfare function can be

written as

S(q

1

+ q

2

) + θq

1

q

2

+ λp

1

(q

1

, q

2

)q

1

−(1 + λ)(ψ(e) + (β −e)q

1

) −cq

2

−λU,

where U = t −ψ(e) is the utility of the monopoly where t is the net transfer (in addition

to reimbursement of cost) from the regulator to the ﬁrm.

2- Characterize the optimal regulation under asymmetric information when the monopoly’s

status quo utility level is zero.

3- We say that the two goods are strategic complements (substitutes) if S

q

1

+S

+θ >

0(< 0).

Show that if the two goods are strategic substitutes a reduction in marginal cost c

reduces eﬀort for the regulated ﬁrm. If the products are strategic complements and λ is

large enough, then a reduction in c increases eﬀort for the regulated ﬁrm.

4- Show that, if the two goods are strategic complements then eﬀort of the regulated ﬁrm

decreases with an increase in the degree of substitution (θ decreases). If the products are

strong enough substitutes, the eﬀort of the regulated ﬁrm increases with the degree of

substitution.

42 EXERCISES

SOLUTIONS

I- ADVERSE SELECTION

Lending with Adverse Selection

1- It is a principal-agent problem with adverse selection. The principal is the bank and

the agent is the borrower. The agent has two possible types: Type 1 obtains h for sure for

an investment of 1. Type 2 obtains h with probability θ in (0, 1) and zero with probability

1 − θ for an investment of 1. The action space is the probability granting a loan and,

when a loan is granted, the level of repayment if the project succeeds (if the project does

not succeed the borrower has no revenue and no wealth). So we have

A = {(P, r) : P ∈ [0, 1]; r ∈ IR

+

}

where P is the probability of receiving a loan and r is the repayment (in case of success).

From the Revelation Principle (Proposition 2.2), we know that we can restrict the

analysis to truthful direct revelation mechanisms, i.e., pairs {(P

1

, r

1

); (P

2

, r

2

)} which are

incentive compatible :

P

1

(h −r

1

) ≥ P

2

(h −r

2

) (1)

P

2

θ(h −r

2

) ≥ P

1

θ(h −r

1

). (2)

2- The bank maximizes its expected proﬁt under the incentive and participation con-

straints, i.e., solves

max

{(P

1

,r

1

);(P

2

,r

2

)}

νP

1

(r

1

−r) + (1 −ν)P

2

(θr

2

−r)

s.t. (1), (2) and

P

1

(h −r

1

) ≥ u (3)

P

2

θ(h −r

2

) ≥ u (4)

43

44 SOLUTIONS

if it wishes to give a loan with positive probability to both types (case 1). Alternatively,

it might oﬀer a loan only accepted by type 1 (case 2).

3- Let us ﬁrst consider case 1 where the bank contracts with both types of borrowers.

Dividing (2) by θ, (1) and (2) imply

P

1

(h −r

1

) = P

2

(h −r

2

). (5)

Since θ is in (0, 1), (4) is binding and not (3). From (4) we have

r

2

= h −

u

θP

2

if P

2

= 0.

From (5) we have

r

1

= h −

u

θP

1

.

Substituting these expressions into the bank’s expected proﬁt we get

νP

1

(h −r) + (1 −ν)P

2

(θh −r) −

νu

θ

−(1 −ν)u.

Since θh > r, maximizing with respect to P

1

and P

2

gives P

1

= P

2

= 1 and r

1

= r

2

=

h −

u

θ

.

Therefore, we obtain a pooling contract with an expected proﬁt for the bank of

ν

h −r −

u

θ

+ (1 −ν)(θh −r −u).

Type 1’s ex post information rent is h −r

1

−u =

(1−θ)

θ

u.

Consider now case 2. The bank oﬀers a loan intended only for type 1. It is only

constrained by type 1’s participation constraint. The bank will obviously make this

constraint binding, leave no information rent to type 1, and provide a loan with probability

one:

r

1

= h −u

with an expected proﬁt for the bank ν(h −r −u).

Case 2 is better for the bank than case 1 if and only if

ν(h −r −u) > ν

h −r −

u

θ

+ (1 −ν)(θh −r −u)

or

(1 −ν)(θh −r −u) < ν

(1 −θ)

θ

u,

i.e., the expected revenue made with type 2 borrowers is less than the expected rent which

must be given up to type 1’s borrowers because of the presence of type 2 borrowers.

45

Why do we obtain a pooling contract if the principal wants both agents to participate?

The utility function of the agent can be written

U(P, r, θ) = Pθ(h −r).

The Spence-Mirrlees condition writes

∂U

∂θ

∂U

∂P

∂U

∂r

=

∂U

∂θ

(h −r)θ

Pθ

= 0

and we obtain pooling because there is no way to screen apart both types. Indiﬀerences

curves of the two types in the (P, r) plan do not cross.

De Meza and Webb (1987), Stiglitz and Weiss (1981), Laﬀont (2003).

46 SOLUTIONS

Bundling with Asymmetric Information

1- Since consumers want to consume only one unit and since only deterministic mech-

anisms are considered, there is no way to screen types with either the quantities they

consume or the probabilities of receiving the good. The seller can only post a price that

a subset of consumers accept to pay.

Given the willingnesses to pay, the three relevant prices that can be posted are θ−ε, θ

or θ + ε, for each good.

If p = θ +ε only 1/3 of the consumers buy and revenue is

1

3

(θ +ε). If p = θ,

2

3

of the

consumers buy and revenue is

2

3

θ. If p = θ −ε all consumers buy and revenue is θ −ε.

Since ε < θ, the optimal single good price is (for each good):

p

∗

= θ if θ ≤ 3ε

= θ −ε if θ > 3ε

with a total revenue for both goods

R

∗

=

4

3

θ if θ ≤ 3ε

= 2(θ −ε) if θ > 3ε.

2- Suppose now that the monopolist can oﬀer a price P

B

for a bundle made of one unit

of each good. Since the willingnesses to pay for the two goods are independent, we have

six possible types of consumers with the following aggregate willingnesses to pay.

Population Preferences Aggregate willingness to pay

1

9

{θ + ε, θ + ε} 2θ + 2ε

2

9

{θ + ε, θ} 2θ + ε

1

9

{θ, θ} 2θ

2

9

{θ + ε, θ −ε} 2θ

2

9

{θ, θ −ε} 2θ −ε

1

9

{θ −ε, θ −ε} 2θ −2ε

Again, the relevant posted prices for the bundle correspond to the willingnesses to

47

pay. It is immediate to see that

P

B

= 2θ if θ ≤ 2ε

= 2θ −ε if θ ∈ [2ε, 5ε]

= 2θ −2ε if θ ≥ 5ε,

with respective revenues worth

4

3

θ if θ ≤ 2ε

16

9

θ −

8

9

ε if θ ∈ [2ε, 5ε]

2θ −2ε if θ ≥ 5ε.

Therefore, for θ in [2ε, 5ε], P

B

= 2θ −ε provides more revenue than the optimal single

good prices.

3- For the optimal prices p

∗

we can obtain the surplus made by each type of consumer

and the associated revenue of the monopolist:

p

∗

= θ p

∗

= θ −ε

Population Preferences Surplus Proﬁt Surplus Proﬁt

1

9

{θ + ε, θ + ε} 2ε 2θ 4ε 2(θ −ε)

2

9

{θ + ε, θ} ε 2θ 3ε 2(θ −ε)

1

9

{θ, θ} 0 2θ 2ε 2(θ −ε)

2

9

{θ + ε, θ −ε} ε θ 2ε 2(θ −ε)

2

9

{θ, θ −ε} 0 θ ε 2(θ −ε)

1

9

{θ −ε, θ −ε} 0 0 0 2(θ −ε)

A successful bundle price must attract some consumers and make more proﬁt with

them than with the optimal single good prices.

Consider the case where θ < 3ε and p

∗

= θ.

A bundle price of 2θ −ε makes positive proﬁt since θ > ε and attracts all consumers

except the (θ − ε, θ − ε) types. It also makes more proﬁt than the optimal single good

prices when

8

9

(2θ −ε) >

4

9

θ

i.e. θ > 2ε.

Adams and Yellen (1976).

48 SOLUTIONS

Incentives and Aid

1- The rich in the South solve

max

{q

R

,q

A

P

}

q

R

+ n

P

θv(q

A

P

)

subject to

n

R

q

R

+ n

P

q

A

P

= n

R

y

R

hence

n

R

θv

(q

A

P

) = 1, (1)

with a status quo utility level of

y

R

−

n

P

n

R

q

A

P

+ n

P

θv(q

A

P

) = U

A

(θ).

For v(·) = log(·),

q

A

P

= n

R

θ,

U

A

(θ) = y

R

+ n

P

θ(log n

R

θ −1).

2- The rich of the South solve

max

{q

R

,q

A

P

}

q

R

+ n

P

θv(q

A

P

)

n

R

q

R

+ nq

A

P

= n

R

y

R

+ n

R

a

with the same result for the consumption of the poor. Unconditional aid is ineﬀective in

helping the poor.

The North oﬀers now a contract (q

P

, a) which speciﬁes the level of aid for a level of

consumption of the poor. It is accepted by the South as long as it gets as much as in the

autarky regime. Hence the program of the North:

max

{q

N

,q

R

,q

P

a}

q

N

+ n

P

v(q

P

)

subject to

n

R

q

R

+ n

P

q

P

= n

R

y

R

+ n

R

a

q

R

+ n

P

θv(q

P

) ≥ U

A

(θ)

49

n

N

q

N

= n

N

y

N

−n

R

a

or

(n

N

+ n

R

θ)v

(q

P

) = 1. (2)

Comparing (1) and (2) we see that the poor in the South consume more. For v(·) =

log(·),

q

P

= n

N

+ n

R

θ instead of n

R

θ.

3- To the previous program we must add incentive constraints. For given a and q

P

, the

rich’s utility is

y

R

+ a −

n

P

n

R

q

P

+ n

P

θv(q

P

).

The incentive constraints are

y

R

+ a −

n

P

n

R

q

P

+ n

P

θv(q

P

) ≥ y

R

+ ¯ a −

n

P

n

R

¯ q

P

+ n

P

θv(¯ q

P

)

y

R

+ ¯ a −

n

P

n

R

¯ q

P

+ n

P

¯

θv(¯ q

P

) ≥ y

R

+ a −

n

P

n

R

q

P

+ n

P

¯

θv(q

P

).

Since the status quo utility level U

A

(θ) depends on the type, there is a potential

problem of countervailing incentives. However we will guess that it is, as usual, the

incentive constraint of the one who wants to lie,

¯

θ, which is binding, as well as the

participation constraint of type θ.

The problem of the principal becomes

max

{¯ a,¯ q

P

;a,q

P

}

ν

¸

y

N

−

n

R

n

N

¯ a + n

P

v(¯ q

P

)

+ (1 −ν)

¸

y

N

−

n

R

n

N

a + n

P

v(q

P

)

y

R

+ ¯ a −

n

P

n

R

¯ q

P

+ n

P

¯

θv(¯ q

P

) = y

R

+ a −

n

P

n

R

q

P

+ n

P

¯

θv(q

P

) (3)

y

R

+ a −

n

P

n

R

q

P

+ n

P

θv(q

P

) = U

A

(θ). (4)

Solving (3) and (4) for ¯ a and a, inserting in the objective function and maximizing

with respect to {¯ q

P

, q

P

} yields

(n

N

+ n

R

¯

θ)v

(¯ q

P

) = 1

(n

N

+ n

R

θ)v

(q

P

) = 1 +

ν

1 −ν

Δθn

R

v

(q

P

).

Asymmetric information leads to a decrease in the poor’s consumption when the rich

of the South are of type θ, i.e., have a low altruistic behavior.

50 SOLUTIONS

With v(·) = log(·), we get:

¯ q

P

= n

N

+ n

R

¯

θ

q

P

= n

N

+ n

R

θ −

ν

1 −ν

Δθn

R

.

It remains to check that the participation constraint of type

¯

θ is satisﬁed as well as

type θ’s incentive constraint. Note that the above solutions are in fact only valid as long

as a ≥ 0, ¯ a ≥ 0. In fact when ν is too large, a = 0 and the poor in the South get the

same utility as under autarky. It happens when

n

N

≤

ν

1 −ν

Δθn

R

or ν ≥

n

N

n

N

+ Δθn

R

.

Azam and Laﬀont (2002).

51

Downsizing a Public Firm

1- Let us rewrite the constraints as

¯

U =

¯

t − ¯ p

¯

θ ≥ t −p

¯

θ = U −pΔθ (1)

U = t −pθ ≥

¯

t − ¯ pθ =

¯

U + ¯ pΔθ (2)

¯

U =

¯

t − ¯ p

¯

θ ≥ 0 (3)

U = t −pθ ≥ 0. (4)

Then, we are back to the familiar formulation and (2) + (3) imply (4). Now, the

“good” type is the θ-type.

2- Adding (1) and (2) implies p ≥ ¯ p. For any implementable pair (p, ¯ p), we have the

following constraints

(p − ¯ p)θ ≤ t −

¯

t ≤ (p − ¯ p)

¯

θ

and (3) implies

¯

t ≥ ¯ p

¯

θ.

The government minimizes the expected transfers νt +(1−ν)

¯

t by choosing

¯

t = ¯ p

¯

θ and

t =

¯

t + (p − ¯ p)θ = pθ + Δθ¯ p.

3- Expected social welfare can be rewritten as:

S(νp + (1 −ν)¯ p) −(1 + λ)νpθ −(1 + λ)(1 −ν)¯ p

¯

θ −λνΔθ¯ p

up to a constant.

If we have

S

(ν) > (1 + λ)

¯

θ + λ

ν

1 −ν

Δθ,

then, ¯ p solves

S

(ν + (1 −ν)¯ p) = (1 + λ)

¯

θ +

λν

1 −ν

Δθ (5)

and p = 1.

If we have instead

(1 + λ)

¯

θ + λ

ν

1 −ν

Δθ > S

(ν) > (1 + λ)θ

we get p = 1 and ¯ p = 0.

52 SOLUTIONS

If, ﬁnally

S

(ν) < (1 + λ)θ,

then p solves

S

(νp) = (1 + λ)θ

and ¯ p = 0.

As (5) shows, for low levels of downsizing, asymmetric information (Δθ) increases the

level of downsizing and leaves it unchanged otherwise.

4- Let w the wage if the worker remains in the ﬁrm and s his severance payment if he

quits. By deﬁnition

t = pw + (1 −p)s = pθ + Δθ¯ p (6)

¯

t = ¯ p ¯ w + (1 − ¯ p)¯ s = ¯ p

¯

θ. (7)

A worker does not regret to have participated if his wage in the ﬁrm is larger than his

outside opportunity and his severance payment is non-negative.

Taking w = θ and ¯ w =

¯

θ ensures the ﬁrst point. Then, from (6) and (7)

¯ s = 0 and s = Δθ

¯ p

1 −p

> 0.

5- The incentive constraints remain unchanged so that the optimization program is now

W = S(νp + (1 −ν)ρ¯ p) −(1 + λ)νpθ −(1 + λ)(1 −ν)¯ p

¯

θ −λνΔθ¯ p

∂W

∂p

= ν[S

−(1 + λ)θ]

∂W

∂¯ p

= (1 −ν)

¸

ρS

−(1 + λ)

¯

θ −λ

ν

1 −ν

Δθ

.

As long as ρθ >

¯

θ +

λ

1+λ

ν

1−ν

Δθ, the solution is as in question 3 except that (5) must

be replaced by

ρS

(ν + (1 −ν)ρ¯ p) = (1 + λ)

¯

θ +

λνΔθ

1 −ν

.

When ρθ <

¯

θ +

λ

1+λ

ν

1−ν

Δθ, the ﬁrst-order conditions would call for p < ¯ p which is

in conﬂict with the implementability condition p ≥ ¯ p. Then, we have bunching at the

optimal contract which solves

max

p

S((ν + (1 −ν)ρ)p) −(1 + λ)(νθ + (1 −ν)

¯

θ)p −λνΔθp

53

i.e.,

S

((ν + (1 −ν)ρ)p) =

(1 + λ)(νθ + (1 −ν)

¯

θ) + λνΔθ

ν + (1 −ν)ρ

.

Jeon and Laﬀont (1999).

54 SOLUTIONS

Labor Contracts

1- The ﬁrm’s problem is

max

{l,t}

f(l) −t subject to u(t) −θl ≥ 0.

So, for θ = θ:

u(t

∗

) = θ l

∗

f

(l

∗

) =

θ

u

(t

∗

)

for θ =

¯

θ:

u(

¯

t

∗

) =

¯

θ

¯

l

∗

f

(

¯

l

∗

) =

¯

θ

u

(

¯

t

∗

)

.

2- The ﬁrst-best allocation {(t

∗

, l

∗

); (

¯

t

∗

,

¯

l

∗

)} is not implementable. Suppose this menu were

oﬀered under asymmetric information. Then, the θ worker will select (

¯

t

∗

,

¯

l

∗

). Indeed, his

utility is then

u(

¯

t

∗

) −θ

¯

l

∗

= Δθ

¯

l

∗

> 0

instead of zero for (t

∗

, l

∗

).

Under asymmetric information, the optimal contract is the solution of

max

{(

¯

t,

¯

l);(t,l)}

ν(f(l) −t) + (1 −ν)(f(

¯

l) −

¯

t),

subject to

u(t) −θ l ≥ u(

¯

t) −θ

¯

l

u(

¯

t) −

¯

θ

¯

l ≥ 0,

where we just consider the relevant incentive and participation constraints.

Let ψ(·) be the inverse function of u(·), i.e., t = ψ(u). The program can be rewritten

as:

max

{(¯ u,

¯

l);(u,l)}

ν[f(l) −ψ(u)] + (1 −ν)[f(

¯

l) −ψ(¯ u)]

u −θ l ≥ ¯ u −θ

¯

l

¯ u −

¯

θ

¯

l ≥ 0.

55

The two constraints are binding. Therefore ¯ u =

¯

θ

¯

l and u = θ l + Δθ

¯

l. Substituting

these values in the employer’s objective function and maximizing with respect to (l,

¯

l)

yields

f

(l

SB

) =

θ

u

(t

SB

)

; u(t

SB

) = θl

SB

+ Δθ

¯

l

SB

f

(

¯

l

SB

) =

¯

θ

u

(

¯

t

SB

)

+

ν

1 −ν

Δθ

u

(t

SB

)

; u(

¯

t

SB

) =

¯

θ

¯

l

SB

.

Since u

(t

SB

) < u

(ψ(θ l

SB

))

f

(l

SB

)u

(ψ(θ l

SB

)) > θ = f

(l

∗

)u

(ψ(θ l

∗

)),

which implies l

SB

< l

∗

since u

< 0 and f

< 0.

Since

f

(

¯

l

SB

) >

¯

θ

u

(

¯

t)

f

(

¯

l

SB

)u

(ψ(

¯

θ

¯

l

SB

)) >

¯

θ = f

(

¯

l

∗

)u

(ψ(

¯

θ

¯

l

∗

)),

we ﬁnally get

¯

l

SB

<

¯

l

∗

.

3- The ﬁrm’s problem is now:

max

{t,l}

f(l) −t s.t. u(t) −θl ≥ V

yields

u(t

∗

) = θl

∗

+ V

f

(l

∗

) · u

(t

∗

) = θ.

Under asymmetric information, the employer’s program is now:

max

{(¯ u,

¯

l);(u,l)}

ν(f(l) −ψ(u)) + (1 −ν)(f(

¯

l) −ψ(¯ u))

u −θl ≥ max(V, ¯ u −θ

¯

l)

¯ u −

¯

θ

¯

l ≥ 0.

If Δθ

¯

l

SB

≥ V , the solution of question 2 is unchanged, since the rent of asymmetric

information is greater or equal to the outside opportunity level of utility.

56 SOLUTIONS

If Δθ

¯

l

SB

< V ≤

¯

l

∗

Δθ, there is no reason to distort so much the production level

of the ineﬃcient type (the θ-incentive constraint and both participation constraints are

binding). The ﬁrm’s problem becomes:

max

{(¯ u,

¯

l);(u,l)}

ν (f(l) −ψ(θl + V )) + (1 −ν)(f(

¯

l) −ψ(

¯

θ

¯

l))

V −Δθ

¯

l ≥ 0 (λ).

It admits the solution:

f

(l) =

θ

u

(t)

, u(t) = θl + Δθ

¯

l

f

(

¯

l) =

¯

θ

u

(

¯

t)

+

λ

1 −ν

Δθ, u(

¯

t) =

¯

θ

¯

l.

If Δθ

¯

l

∗

< V < Δθl

∗

, there is no reason to distort the production level of the ineﬃcient

type and the solution is characterized by (only the participation constraints are binding)

f

(l) =

θ

u

(t)

; t = θl + V

f

(

¯

l) =

¯

θ

u

(

¯

t)

;

¯

t =

¯

θ

¯

l.

However, if V becomes greater than Δθl

∗

, the

¯

θ-incentive constraint is binding and

the ﬁrm’s problem becomes:

max

{(¯ u,

¯

l);(u,l)}

ν(f(l) −ψ(u)) + (1 −ν)(f(

¯

l) −ψ(¯ u))

¯ u −

¯

θ

¯

l ≥ u −

¯

θl = V −Δθl

u −θl = V

¯ u −

¯

θ

¯

l ≥ 0.

There exists two subcases. In the ﬁrst one, the

¯

θ-incentive constraint and both par-

ticipation constraints are binding.

max

{l,

¯

l}

ν(f(l) −ψ(θl + V )) + (1 −ν)(f(

¯

l) −ψ(

¯

θ

¯

l + V ))

−V + Δθl ≥ 0 (λ)

f

(

¯

l) =

¯

θ

u

(

¯

t)

; u(

¯

t) =

¯

θ

¯

l

f

(l) =

θ

u

(t)

−

λ

ν

Δθ ; u(t) = θl + V.

57

l is increased to reduce the information rent to zero.

Let

ˆ

l

SB

be deﬁned by

f

(

ˆ

l

SB

) =

θ

u

(t

SB

)

−

1 −ν

ν

Δθ

u

(

¯

t

SB

)

; u(t

SB

) = θ

ˆ

l

SB

+ Δθ

ˆ

l

SB

f

(

¯

l

SB

) =

¯

θ

u

(

¯

t

SB

)

; u(

¯

t

SB

) =

¯

θ

¯

l

SB

.

If V > Δθ

ˆ

l

SB

, then only the

¯

θ-incentive constraint and the θ-participation constraint

are binding and the solution is characterized by:

f

(l) =

θ

u

(t)

−

1 −ν

ν

Δθ

u

(

¯

t)

; u(t) = θl + V

f

(

¯

l) =

¯

θ

u

(

¯

t)

; u(

¯

t) =

¯

θ

¯

l + V −Δθl.

58 SOLUTIONS

Control of Self-Managed Firm

1- The optimal size of the self-managed ﬁrm is the solution to

max

pθ

1/2

−A

i.e.

LM

=

2A

pθ

2

.

2- The optimal allocation of labor is determined by equating the marginal product of

labor to the wage w,

1

2

pθ

−1/2

= w or

∗

=

pθ

2w

2

.

If w is small, the self-managed ﬁrm, which maximizes added value per capita and not

proﬁt, restricts the size of the ﬁrm with respect to the optimal size. If w is larger than

the per capita added value for

LM

the workers of the labor managed will quit to beneﬁt

from the high wage elsewhere in the economy. From now on we assume that w is small

enough to justify the presence of the labor managed ﬁrm (LM ﬁrm).

3- The LM ﬁrm solves now

max

(p −τ)θ

1/2

−A

,

hence

=

2A

(p −τ)θ

2

.

To achieve eﬃciency we need to equate this term to

∗

, i.e.

τ = p −

4Aw

pθ

2

.

If instead we use a lump sum tax, the LM ﬁrm solves

max

pθ

1/2

−A −T

,

hence

=

2(A + T)

pθ

2

.

To achieve eﬃciency we need

T =

p

2

θ

2

4w

−A.

59

4- Incentive constraints are

p

¯

θ

¯

1/2

+

¯

t −A

¯

≥

p

¯

θ

1/2

+ t −A

(1)

pθ

1/2

+ t −A

≥

pθ

¯

1/2

+

¯

t −A

¯

. (2)

Adding those two incentive constraints we get

p(

¯

θ −θ)(

¯

−1/2

−

−1/2

) ≥ 0 or

¯

≤ .

5- The government’s program is

max

{(,t);(

¯

,

¯

t)}

ν(pθ

1/2

−w) + (1 −ν)(p

¯

θ

¯

1/2

−w

¯

),

subject to (1)-(2) and

p

¯

θ

¯

1/2

+

¯

t −A

¯

≥ 0 (3)

pθ

1/2

+ t −A

≥ 0. (4)

The ﬁrm’s objective function is

U(, t, θ) = pθ

−1/2

−A

−1

−t

−1

.

∂

∂θ

∂U/∂

∂U/∂t

=

1

2

p

−1/2

> 0,

and we could expect the usual constraints to be binding.

However, the benevolent government is only interested in eﬃciency and would like to

implement

∗

=

pθ

2w

2

;

¯

∗

=

p

¯

θ

2w

2

i.e.

¯

∗

>

∗

. This ﬁrst-best allocation is not implementable.

Therefore, the optimal solution entails bunching and does not exploit the information

of the agent. It is obtained from the program:

max

{}

(νθ + (1 −ν)

¯

θ)¯ p

1/2

−w,

or

=

p(νθ + (1 −ν)

¯

θ)

2w

2

.

Here, there is a total conﬂict between the implementability condition and the proﬁle

of allocations that the principal is interested in.

Guesnerie and Laﬀont (1984).

60 SOLUTIONS

Information and Incentives

1-

max

{(t,q)}

S(q) −t subject to t −θq ≥ 0

yields

S

(q) = θ ; t = θq.

2-

max

{(

¯

t,¯ q);(t,q)}

ν(S(q) −t) + (1 −ν)(S(¯ q) −

¯

t)

subject to

t −θq ≥

¯

t −θ¯ q

¯

t −

¯

θ¯ q ≥ t −

¯

θq

t −θq ≥ 0

¯

t −

¯

θ¯ q ≥ 0,

yields

S

(q

∗

) = θ ; t = θq

∗

+ Δθ¯ q

S

(¯ q) =

¯

θ +

ν

1 −ν

Δθ ;

¯

t =

¯

θ¯ q.

3-

ν = Pr(θ = θ|σ = σ) =

νμ

νμ + (1 −ν)(1 −μ)

¯ ν = Pr(θ = θ|σ = ¯ σ) =

ν(1 −μ)

ν(1 −μ) + (1 −ν)μ

.

For each value of σ (σ and ¯ σ), the optimal contract is characterized as in question 2,

where ν is replaced by ν and ¯ ν respectively.

4- For any μ, the information structure is characterized by the matrix

F =

¸

Pr(σ = σ|θ = θ) Pr(σ = σ|θ =

¯

θ)

Pr(σ = ¯ σ|θ = θ) Pr(σ = ¯ σ|θ =

¯

θ)

or

F

1

=

¸

μ 1 −μ

1 −μ μ

.

61

For μ −Δμ

F

2

=

¸

μ −Δμ 1 −μ + Δμ

1 −μ + Δμ μ −Δμ

.

F

1

is an improvement in the sense of Blackwell if there exists a bistochastic matrix B

such that F

2

= BF

1

.

Take

B =

¸

1 −

Δμ

2μ−1

Δμ

2μ−1

Δμ

2μ−1

1 −

Δμ

2μ−1

¸

.

In a classical statistical decision problem, the utility of the decision-maker increases

for an improvement of his information in the Blackwell sense. Here it is not necessarily

the case.

5- Let W(μ) denote the expected utility of the principal (with obvious notations):

W(μ) = Pr(σ = σ)

Pr(θ = θ|σ = σ)(S(q

∗

) −θq

∗

−Δθ¯ q(σ, μ)

+Pr(θ =

¯

θ|σ = σ)

S(¯ q(σ, μ) −

¯

θ¯ q(σ, μ))

+ Pr(σ = ¯ σ)

Pr(θ = θ|σ = ¯ σ)(S(q

∗

) −θq

∗

−Δθ¯ q(¯ σ, μ)

+Pr(θ =

¯

θ|σ = ¯ σ)

S(¯ q(¯ σ, μ) −

¯

θ¯ q(¯ σ, μ))

.

This expression can be written symbolically

σ

¸

θ|σ

F(q, θ, μ, σ)dG(θ|σ)

dH(σ).

The diﬀerence with a classical decision problem is that F(·) depends here directly on

the precision μ of the signal and the signal σ, because of the presence of the information

rents Δθ¯ q(¯ σ, μ) and Δθ¯ q(σ, μ) in the principal’s objective function.

Therefore

dW

dμ

=

∂W

∂μ

μ ﬁxed in F(q,θ,μ)

. .. .

Blackwell’s eﬀect

+

σ

θ|σ

∂F

∂μ

dG(θ|σ)dH(σ)

. .. .

New eﬀect

.

6- The expected utility of the principal can be rewritten

W = νμ[S(q

∗

) −θq

∗

−Δθ¯ q(σ, μ)]

+(1 −ν)(1 −μ)[S(¯ q(σ, μ)) −

¯

θ¯ q(σ, μ)]

+ν(1 −μ)[S(q

∗

) −θq

∗

−Δθ¯ q(¯ σ, μ)]

+(1 −ν)μ[S(¯ q(¯ σ, μ)) −

¯

θ¯ q(¯ σ, μ)].

62 SOLUTIONS

By the Envelop Theorem we have:

dW

dμ

= −νΔθ¯ q(σ, μ) −(1 −ν)[S(¯ q(σ, μ)) −

¯

θ¯ q(σ, μ)]

+νΔθ¯ q(¯ σ, μ) + (1 −ν)[S(¯ q(¯ σ, μ)) −

¯

θ¯ q(¯ σ, μ)]

= (1 −ν)

¯ q(¯ σ,μ)

¯ q(σ,μ)

¸

S

(q) −

¯

θ +

ν

1 −ν

Δθ

dq > 0,

since ¯ q(¯ σ, μ) > ¯ q(σ) and S

(¯ q(¯ σ, μ)) >

¯

θ.

63

The Bribing Game

Let (t, q) and (

¯

t, ¯ q) the contracts oﬀered where t (resp.

¯

t) is the bribe requested for a

decrease of delay q (resp. ¯ q).

The principal’s program is

max

{(

¯

t,¯ q);(t,q)}

ν

t −

(q −Q)

2

2

+ (1 −ν)

¯

t −

(¯ q −Q)

2

2

subject to

θq −t ≥ θ¯ q −

¯

t

¯

θ¯ q −

¯

t ≥

¯

θq −t

θq −t ≥ u

0

¯

θ¯ q −

¯

t ≥ u

0

.

As usual t = θq + u

0

;

¯

t =

¯

θ¯ q −Δθq + u

0

hence the solution

¯ q = Q +

¯

θ

q = Q + θ −

1 −ν

ν

Δθ.

Agents who value more time are oﬀered a higher decrease of delay.

This exercise ??? from Saha (2001).

64 SOLUTIONS

Regulation of Pollution

1- Let x

∗

(θ) the solution of

D

(x) + C

x

(x, θ) = 0. (1)

If the ﬁrms must pay t(x) = D(x) + K it solves

min

x

{D(x) + C(x, θ) + K}

yielding (1).

2-

max

{x,t}

{−D(x) −(1 + λ)t + t −C(x, θ)}

subject to

t −C(x, θ) ≥ 0.

Let U = t −C(x, θ). The program can be rewritten

max{−D(x) −(1 + λ)C(x, θ) −λU}

subject to

U ≥ 0

hence, the solution is

D

(x) + (1 + λ)C

x

(x, θ) = 0,

t = C(x, θ).

The participation constraint requires now the use of public money which has an oppor-

tunity cost of 1 +λ. So the marginal disutility of pollution is equal to the social marginal

cost of depollution −(1 + λ)C

x

(x, θ) which includes the ﬁnancial cost.

3- Under incomplete information the regulator maximizes expected social welfare under

the incentive and participation constraint of the ﬁrm

max

{(x,U);(¯ x,

¯

U)}

ν (−D(x) −(1 + λ)C(x, θ) −λU) + (1 −ν)

−D(¯ x) −(1 + λ)C(¯ x,

¯

θ) −λ

¯

U

,

subject to

65

U ≥

¯

U + C(¯ x,

¯

θ) −C(¯ x, θ) (2)

¯

U ≥ U + C(x, θ) −C(x,

¯

θ) (3)

U ≥ 0 (4)

¯

U ≥ 0, (5)

where we use the notation U = t −C(x, θ);

¯

U =

¯

t −C(¯ x,

¯

θ).

As usual since C

θ

< 0,

¯

θ is the eﬃcient type and U = 0 and

¯

U = C(x, θ) −C(x,

¯

θ).

Hence, the solution

D

(¯ x) + (1 + λ)C

x

(¯ x,

¯

θ) = 0

D

(x) + (1 +λ)C

x

(x, θ) +

1 −ν

ν

λ[C

x

(x, θ) −C

x

(x,

¯

θ)] = 0.

Since D

≥ 0, C

xx

> 0 and C

xθ

< 0, ¯ x is greater than the full information level.

Depollution is more costly because of the information rent which must be given up to

elicit the information.

4- Let U(θ) = t(θ) − C(x(θ), θ) the level of utility of the truthful ﬁrm when it is faced

with the DRM (t(θ), x(θ)). The local incentive constraints are

˙

U(θ) = −C

θ

(x(θ), θ) (6)

˙ x(θ) ≥ 0,

since the ﬁrst-order condition of incentive compatibility is

˙

t(θ) −C

x

(x(θ), θ) ˙ x(θ) = 0

and (6) follows from the Envelope Theorem.

The second order condition is −C

xθ

(x(θ), θ) ˙ x(θ) ≥ 0 or ˙ x ≥ 0 since C

xθ

< 0.

The regulator’s optimization program is

max

{x(·),U(·)}

¯

θ

θ

{−D(x(θ)) −(1 + λ)C(x(θ), θ) −λU(θ)} dF(θ)

subject to

˙

U(θ) = −C

θ

(x(θ), θ) (−μ(θ))

˙ x(θ) ≥ 0

U(θ) ≥ 0 for all θ.

Since C

θ

< 0, the participation constraint reduces to U(θ) ≥ 0.

66 SOLUTIONS

The Hamiltonian is

H = (−D(x) −(1 + λ)C(x, θ) −λU)f(θ) −μC

θ

(x, θ).

Since there is no constraint at θ =

¯

θ, the transversality condition implies μ(

¯

θ) = 0.

From the Pontryagin condition

˙ μ(θ) = −

∂H

∂U

= λf(θ)

hence

μ(

¯

θ) −μ(θ) = λ(1 −F(θ))

or

μ(θ) = −λ(1 −F(θ)).

Maximizing H with respect to x we obtain ﬁnally

D

(x(θ)) + (1 + λ)C

x

(x(θ), θ) −

λ(1 −F(θ))

f(θ)

C

θx

(x(θ), θ) = 0.

There is no distortion at θ =

¯

θ, and since C

θx

< 0 and D

≥ 0, C

xx

> 0, an downward

distortion of pollution for all the other types.

It remains to check that the second order condition is satisﬁed, i.e., ˙ x(θ) ≥ 0. A

suﬃcient condition is

d

dθ

1 −F(θ)

f(θ)

≤ 0 ; C

θθx

< 0; C

xxθ

≥ 0.

See Groves and Loeb (1975), Aspremont and G´erard-Varet (1979).

67

Taxation of a Monopoly

1- Because utility functions are quasi-linear all interior Pareto optima are obtained by

maximizing the utilitarian criterion under the resource constraint of the economy, i.e.,

max

{(q(θ),x(θ));(q(

¯

θ),x(

¯

θ))}

ν[θ log q(θ) + x(θ)] + (1 −ν)[

¯

θ log q(

¯

θ) + x(

¯

θ)]

subject to

νx(θ) + (1 −ν)x(

¯

θ) = ¯ x −c[νq(θ) + (1 −ν)q(

¯

θ)] −K

i.e.,

q(θ) =

θ

c

and q(

¯

θ) =

¯

θ

c

.

2- A θ-consumer’s utility function writes θ log q + x

∗

− t where x

∗

is a ﬁxed parameter

and t is the payment made to the monopoly. Incentive constraints are then

θ log q −t ≥ θ log ¯ q −

¯

t (1)

¯

θ log ¯ q −

¯

t ≥

¯

θ log q −t. (2)

3- The monopoly’s maximization program is then

max

{(t,q);(

¯

t,¯ q)}

ν(t −cq) + (1 −ν)(

¯

t −c¯ q)

subject to (1)-(2) and

θ log q −t ≥ 0 (3)

¯

θ log ¯ q −

¯

t ≥ 0. (4)

We can expect (3) and (2) to be binding. Hence t = θ log q and

¯

t =

¯

θ log ¯ q −Δθ log q.

Inserting in the objective function of the monopoly and maximizing with respect to q and

¯ q, we obtain

¯ q =

¯

θ

c

; q =

θ

c

−

(1 −ν)

ν

Δθ

c

.

4- When τ is the tax, the monopoly’s problem becomes

max

{(t,q);(

¯

t,¯ q)}

ν(t −cq) + (1 −ν)(

¯

t −c¯ q)

subject to

θ log q −t −τq ≥ 0

68 SOLUTIONS

¯

θ log ¯ q −

¯

t −τ ¯ q ≥

¯

θ log q −t −τq

where we just write the relevant constraints or

max

{q,¯ q}

ν

θ log q −(c + τ)q

+ (1 −ν)

¯

θ log ¯ q −(c + τ)¯ q −Δθ log q

hence

¯ q =

¯

θ

c + τ

; q =

θ

c + τ

−

(1 −ν)

ν

Δθ

c + τ

. (5)

Everything happens as if the marginal cost was ˜ c = c + τ instead of c.

The government’s problem is then

max

τ

(1 −ν)Δθ log q + σ

ν(θ log q −(c + τ)q) + (1 −ν)(

¯

θ log ¯ q −(c + τ)¯ q −Δθ log q)

+λ(νq + (1 −ν)¯ q)τ

¸

subject to (5).

The maximand can be rewritten

Δθ(1 −σ)(1 −ν) log q + σνθ log q + σ(1 −ν)

¯

θ log ¯ q + (λτ −σ(c + τ))(νq + (1 −ν)¯ q).

The derivative with respect to τ is

¸

(1 −σ)(1 −ν)Δθ

q

+

σνθ

q

+ ν(λτ −σ(c + τ))

dq

dτ

+

¸

σ(1 −ν)

¯

θ

¯ q

+ (1 −ν)(λτ −σ(c + τ))

d¯ q

dτ

+(λ −σ)(νq + (1 −ν)¯ q).

Using (5) this expression becomes

dq

dτ

¸

(1 −ν)Δθ

q

+ νλτ

+

d¯ q

dτ

(1 −ν)λτ + (λ −σ)(νq + (1 −ν)¯ q). (6)

For λ > 0 and σ ≥ λ, (6) is negative for τ > 0. Also τ is bounded below by −c (see

(5)). The interior solution is then:

τ = −

(λ −σ)(νq + (1 −ν)¯ q) +

1−ν

q

Δθ

dq

dτ

λ

ν

dq

dτ

+ (1 −ν)

d¯ q

dτ

< 0.

5- Let U(θ) = θ log q(θ) −t(θ) be the utility of a θ-consumer. By the envelope theorem,

the incentive constraints are

˙

U(θ) = log q(θ) (7)

˙ q(θ) ≥ 0 for all θ. (8)

69

The monopoly’s maximization program is

max

{t(·),q(·),U(·)}

¯

θ

θ

(t(θ) −cq(θ))dF(θ) =

¯

θ

θ

(θ log q(θ) −cq(θ) −U(θ))dF(θ)

subject to (7)-(8) and U(θ) ≥ 0.

The Hamiltonian is

H = (θ log q(θ) −cq(θ) −U(θ))f(θ) + μ(θ) log q(θ).

Since U is increasing, there is no constraint at θ =

¯

θ so that μ(

¯

θ) = 0. From the

Pontryagin principle

˙ μ(θ) = −

∂H

∂U

= f(θ). (9)

Integrating (9) between

¯

θ and θ we get μ(

¯

θ)−μ(θ) = F(

¯

θ)−F(θ) or μ(θ) = −(1−F(θ)).

Maximizing with respect to q(·) we obtain ﬁnally

θ

q(θ)

= c +

1 −F(θ)

f(θ)

1

q(θ)

or

q

SB

(θ) =

θ −

1−F(θ)

f(θ)

c

with no distortion at the top only.

In the case of a uniform distribution on [2, 3], F(θ) = θ −2 and c = 1:

q(θ) = 2θ −3 or θ(q) =

3 + q

2

t(θ) = θ log q(θ) −

θ

θ

log q(u)du

T(q) = t(θ(q)) =

3

2

+

q

2

log q −

3

2

+

q

2

2

log q(u)du

dT

dq

=

1

2

+

3

2q

+

1

2

log q −

1

2

log

3

2

+

q

2

2

d

2

T

dq

2

= −

3 + a

2q

2

.

T(·) is concave. There is a discount for buying more (see ﬁgure below).

70 SOLUTIONS

E

T

•

•

•

1

2

3

1 2 3

θ

q

∗

(θ)

q

SB

(θ)

71

Shared Information Goods, Majority Voting and Op-

timal Pricing

1- The monopolist’s optimization program is:

max

{q(·);U(·)}

3

2

1

¸

θq(θ) −

q(θ)

2

2

−U(θ)

dθ

subject to

˙

U(θ) = q(θ)

˙ q(θ) ≥ 0,

yielding q(θ) = 2(θ −1) and an expected proﬁt for the monopolist

π

I

=

3

2

2

1

[2(θ −1)]

2

dθ = 2.

2- Let G(θ) the cumulative distribution function of the median of the types and g(θ) its

density function. The monopolist’s program is:

max

{q(·);U(·)}

2

1

3

¸

θq(θ) −

q(θ)

2

2

−U(θ)

dG(θ)

˙

U(θ) = q(θ)

˙ q(θ) ≥ 0,

yielding q(θ) = θ −

1−G(θ)

g(θ)

and an expected proﬁt for the monopolist

π

II

=

3

2

2

1

¸

θ −

1 −G(θ)

g(θ)

dG(θ).

Given that G(θ) = (5 −2θ)(θ −1)

2

, we can check that q(θ) is increasing in θ. Let θ(q)

be its inverse function. As

U(θ) = θq(θ) −

q(θ)

2

2

−t(θ)

T(q) = t(θ(q)) = θ(q)q −

q

2

2

−

θ(q)

1

q(u)du.

Then each agent’s utility function is single-peaked, and the majority rule yields the choice

of the median agent. Indeed

V (θ, q) = θq −

q

2

2

−T(q)

yields

V

qq

(θ, q) = −θ

(q) < 0.

3- G(θ) = (θ −1)

2

(5 −2θ). Then π

I

= 2 and π

II

≈ 9.25.

72 SOLUTIONS

Labor Contract with Adverse Selection

1- Since the observables of the principal are y and t

A = {y, t, y ∈ IR

+

and t ∈ IR} .

From the Revelation Principle, we can restrict the analysis to the pair of contracts

(y, t)(¯ y,

¯

t). The agent’s incentive constraints are

t −ψ(θy) ≥

¯

t −ψ(θ¯ y) (1)

¯

t −ψ(

¯

θ¯ y) ≥ t −ψ(

¯

θy). (2)

2- The principal’s optimization program is:

max

{(y,t),(¯ y,

¯

t)}

ν[y −t] + (1 −ν)[¯ y −

¯

t]

subject to (1)-(2) and

t −ψ(θy) ≥ 0 (3)

¯

t −ψ(

¯

θ¯ y) ≥ 0. (4)

We can expect the participation constraint of the ineﬃcient type (4) and the incentive

constraint of the eﬃcient type (1) to be binding. Hence

¯

t = ψ(

¯

θ¯ y) and t = ψ(θy) + ψ(

¯

θ¯ y) −ψ(θ¯ y).

Substituting these solutions in the principal’s objective function and maximizing with

respect to y, ¯ y we obtain:

ψ

() = ψ

(θy) =

1

θ

;

ψ

(

¯

) = ψ

(

¯

θ¯ y) =

1

¯

θ

−

ν

1 −ν

¯

θψ

(

¯

) −θψ

()

¯

θ

.

The marginal disutility of labor is equated to its marginal productivity for the eﬃcient

type. It is distorted downwards for the ineﬃcient type. (3) is implied by (4) and (1). (2)

becomes:

0 ≥ −ψ(

¯

θy) + ψ(θy) + ψ(

¯

θ¯ y) −ψ(θ¯ y)

or

0 ≥ ¯ y

¯

θ

θ

ψ

(θ¯ y)dθ −y

¯

θ

θ

ψ

(θy)dθ

73

or

0 ≥ (¯ y −y)

¯

θ

θ

ψ

(θ¯ y)dθ −y

¯

θ

θ

θ

y

¯ y

ψ

(θy)dydθ. (5)

From the optimal solution >

¯

implies y > ¯ y hence (5) holds.

Indeed the Spence-Mirrlees condition writes here. If U = (t −ψ(θy)),

∂

∂θ

∂U

∂y

∂U

∂t

=

∂

∂θ

(−θψ

(θy)) = −ψ

−θyψ

< 0,

and we know from Section 2.11 that the problem is well behaved and the constraints are

binding as we guessed.

Chari (1983), Green and Kahn (1983), Hart (1983a), Hart and Holmstr¨ om (1987).

74 SOLUTIONS

II- MORAL HAZARD

Lending with Moral Hazard

The optimization problem of the bank is:

max

x≥0

¯ p(z −x) −r

subject to

¯ px −ψ ≥ px (1)

¯ px −ψ ≥ 0. (2)

The incentive constraint (1) implies x =

ψ

¯ p−p

. From (2) the expected rent of the

entrepreneur is:

R =

pψ

¯ p −p

.

The bank’s expected proﬁt is

¯ pz −

¯ pψ

¯ p −p

−r.

Hence, the optimal individual contract entails a loan which induces eﬀort if

¯ pz ≥ ψ + r +

pψ

¯ p −p

.

Otherwise, there is no lending.

75

Moral Hazard and Monitoring

1- Since p

L

= 0, it is worth ﬁnancing the project only if one can design a contract which

induces eﬀort e

H

, satisﬁes the entrepreneur’s participation constraint and ensures non

negative proﬁt, i.e.,

p

H

(R −P) ≥ B (1)

p

H

(R −P) ≥ 0 (2)

p

H

P ≥ I. (3)

From (1), P = R −

B

p

H

and from (3) p

H

R ≥ B + I.

2- p

H

R > I but p

H

R < B + I and m < p

H

R.

It is immediate to check that there is no pure strategy equilibrium. Let us compute the

mixed strategy equilibrium. Let μ

1

= Pr(e = e

H

), μ

2

= Pr (Monitor). The entrepreneur

must be indiﬀerent between the two eﬀort levels, i.e.

μ

2

p

H

(R −P) + (1 −μ

2

)p

H

(R −P) = μ

2

×0 + (1 −μ

2

) · B

or

p

H

(R −P) = (1 −μ

2

)B.

The lender must be indiﬀerent between monitoring or not, i.e.

μ

1

[p

H

P −m] + (1 −μ

1

)(p

H

R −m) = μ

1

p

H

P

or

m = (1 −μ

1

)p

H

R.

The participation constraint of the entrepreneur is

p

H

(R −P) ≥ 0.

So the bank can now choose a best repayment of P = R. The mixed strategy equilib-

rium entails μ

2

= 1 and μ

1

= 1 −

m

p

H

R

. But then the eﬀort is always high since the lender

always monitors. Lending occurs if

p

H

R −m ≥ I.

76 SOLUTIONS

Inducing Information Learning

1- From Bayes rule

Pr(

¯

S|¯ σ) =

Pr(¯ σ|

¯

S) Pr(

¯

S)

Pr(¯ σ)

=

θν

θν + (1 −θ)(1 −ν)

E(S|¯ σ) =

θν

¯

S + (1 −θ)(1 −ν)S

θν + (1 −θ)(1 −ν)

=

(2θ −1)ν

¯

S

θν + (1 −θ)(1 −ν)

> 0

E(S|σ) =

(1 −θ)ν

¯

S + θ(1 −ν)S

(1 −θ)ν + θ(1 −ν)

=

(1 −2θ)ν

¯

S

(1 −θ)ν + θ(1 −ν)

< 0.

So, the principal chooses the risky project if σ = ¯ σ and the safe project if σ = σ. His

expected utility if he decides to learn information is

(2θ −1)ν

¯

S −ψ,

and learning is optimal if this expression is positive.

2- The agent chooses the risky project if he learns ¯ σ when

θν

¯

t

θν + (1 −θ)(1 −ν)

+

(1 −θ)(1 −ν)t

θν + (1 −θ)(1 −ν)

≥ t

0

. (1)

He chooses the safe project if he learns σ when

(1 −θ)ν

¯

t

(1 −θ)ν + θ(1 −ν)

+

θ(1 −ν)t

(1 −θ)ν + θ(1 −ν)

≤ t

0

. (2)

3- Ex ante, the agent decides to learn information if

θν

¯

t + (1 −θ)(1 −ν)t + [(1 −θ)ν + θ(1 −ν)]t

0

−ψ ≥ t

0

(3)

≥ νt + (1 −ν)

¯

t. (4)

(3) (resp. (4)) says that he prefers to learn the information (and follow the optimal choices

induced by (1), (2)) rather than not learning and always choosing the safe project (resp.

not learning and always choosing the risky project).

4- But, note that (3) implies (1) and (4) implies (2). If the principal induces the agent

to learn information then the agent’s decision rule is optimal. Since the principal wants

to minimize payments he chooses

t = 0

t

0

=

ψ

(2θ −1)(1 −ν)

¯

t =

ψ

(2θ −1)ν(1 −ν)

.

77

The principal’s expected utility is then

(2θ −1)ν

¯

S −θν

¯

t −[(1 −θ)ν + θ(1 −ν)]t

0

= (2θ −1)ν

¯

S −ψ ·

¸

θ + (1 −θ)ν + θ(1 −ν)

(2θ −1)(1 −ν)

. (5)

5- It is worth inducing information revelation only if (5) is positive. This happens less

often than if the principal was using the information technology himself since (5) can be

rewritten

(2θ −1)ν

¯

S −ψ −

ψ

(2θ −1)(1 −ν)

.

Otherwise, he should not use the agent.

Inspired from Gromb and Martimort (2002).

78 SOLUTIONS

Optimal Contract and Limited Liability

1- The optimal contract solves the following problem

max

e

¯ q

0

qf(q|e)dq −ψ(e)

Assuming the f(·) satisﬁes CDFC, we have a strictly concave objective function and

the optimal ﬁrst-best eﬀort solves

¯ q

0

qf

e

(q|e

∗

)dq = ψ

(e

∗

).

2- The incentive constraint is

¯ q

0

t(q)f

e

(q|e)dq = ψ

(e), (1)

provided the agent’s objective function is strictly concave. It is when t

(q) > 0, and f(·)

satisﬁes CDFC.

The participation constraint is

¯ q

0

t(q)f(q|e) −ψ(e) ≥ 0. (2)

3- The principal’s problem becomes:

max

0≤t(q)≤q

¯ q

0

(q −t(q))f(q|e)dq

subject to (1) and (2).

Writing the Lagrangian, we get:

L(q, t, e) = (q −t)f(q|e) + λ[tf

e

(q|e) −ψ

(e)] + μ[tf(q|e) = ψ(e)],

for t ∈ [0, q] where λ and μ are respectively the multipliers of (1) and (2) (μ ≥ 0 because

(2) is an inequality.

The objective is linear in t and the solution has a bang-bang feature

if (μ −1)f(q|e) + λf

e

(q|e) > 0 then t = q

if (μ −1)f(q|e) + λf

e

(q|e) < 0 then t = 0

if (μ −1)f(q|e) + λf

e

(q|e) = 0 then t ∈ [0, q].

Note that MLRP ensures that there exists a unique q

∗

such that

fe(q|e)

f(q|e)

>

1−μ

λ

for

q ≥ q

∗

.

Hence t = q iﬀ q ≥ q

∗

, t = 0 otherwise.

79

The Value of Information under Moral Hazard

1- The agent solves

max

e

E

˜

θ

(

˜

θ + e)

¯

t −ψ(e)

and we get

ψ

(e) =

¯

t.

The principal solves

max

e

e

¯

S + (1 −e)S −ψ

(e)e

which yields

ΔS = ψ

(e

SB

) + e

SB

ψ

(e

SB

).

2- Now the agent adjusts his eﬀort e to have always a probability of success of R, i.e.,

e + θ = R or e = R −θ.

He must be paid

E

˜

θ

(ψ

(e)) = E

˜

θ

(ψ

(R −

˜

θ))

to guarantee an eﬀort R.

The principal solves

R

¯

S + (1 −R)S −E

˜

θ

(E

˜

θ

ψ

(R −

˜

θ))

and the ﬁrst-order condition is

ΔS = E

˜

θ

(ψ

(R −

˜

θ) + Rψ

(R −

˜

θ)).

From ψ

**> 0 and Jensen’s inequality, we have E
**

˜

θ

(ψ

(R −

˜

θ)) ≥ ψ

(R) and E

˜

θ

(ψ

(R −

˜

θ)) ≥ ψ

(R) hence R

SB

< e

SB

.

80 SOLUTIONS

Raising Liability Rule

1- The optimal level of eﬀort is determined by minimizing h(1 − e) + ψ(e), i.e. by

ψ

(e

∗

) = h. Social welfare is then

V −(1 + r)I −(1 −e

∗

)h −ψ(e

∗

) > 0. (1)

2- The proper incentive for the agent is obtained by choosing

¯

t and t such that

ψ

(e

∗

) =

¯

t −t.

The agent’s participation constraint can be made binding by choosing t high enough

V −(1 + r)I −e

∗

¯

t −(1 −e

∗

)t −ψ(e

∗

) = 0.

But then the payment to the bank

e

∗

t + (1 −e

∗

)

¯

t = V −(1 + r)I −ψ(e

∗

) > (1 −e

∗

)h

is from (1) enough to pay h to the third party, when damage happens.

3- If the limited liability constraint of the borrower is binding, we have

¯

t = w

t = w −ψ

(e

∗

),

and the expected revenue of the bank is

w −(1 −e

∗

)ψ

(e

∗

)

which must be larger than

(1 + r)I + (1 −e

∗

)c.

Clearly, as w decreases this may become impossible.

4- This contract solves

max

{e,

¯

t,t}

V −et −(1 −e)

¯

t −ψ(e)

subject to

¯

t −t = ψ

(e)

¯

t ≤ w

e

¯

t + (1 −e)t = (1 + r)I + (1 −e)c,

81

where the latter constraint is the bank’s zero proﬁt condition.

This yields

max

e

V −w + (1 −e)ψ

(e) −ψ(e)

subject to

w −eψ

(e) = (1 + r)I + (1 −e)c.

Therefore e is determined by the zero proﬁt constraint

(1 −e)c + eψ

(e) = w −(1 + r)I.

5-

de

dc

= −

1 −e

ψ

+ eψ

−c

< 0

for c small.

6- The bank’s program is then

max

{e,

¯

t,t}

e

¯

t + (1 −e)t −(1 −e)c

¯

t −t = ψ

(e)

¯

t = w

which reduces to

max

e

w −eψ

(e) −(1 −e)c

or

eψ

(e) + ψ

(e) = c

with

de

dc

=

1

eψ

+ 2ψ

> 0.

82 SOLUTIONS

Risk-Averse Principal and Moral Hazard

1- If the agent is risk neutral he will insure completely the principal so that:

t = q −k and

¯

t = ¯ q −k

which implies

¯

t −t = Δq and ψ

(e

∗

) = Δq.

Finally, k is chosen to extract all the agent’s surplus

e

∗

¯ q + (1 −e

∗

)q −ψ(e

∗

) = k.

2- If the agent is protected by limited liability we get instead the standard results,

t = 0

¯

t = ψ

(e).

The participation constraint of the agent is satisﬁed from the convexity of ψ(e) since

ψ convex and ψ(0) ≥ 0 implies

eψ

(e) −ψ(e) ≥ 0.

The principal solves

max

e

e

1 −exp(−ρ(¯ q −ψ

(e)))

ρ

+ (1 −e)

1 −exp(−ρq)

ρ

.

This yields the following ﬁrst-order condition

Δq = ψ

(e

SB

) +

1

ρ

ln(ρ + e

SB

ψ

(e

SB

)).

If ρ →0, ψ

(e

SB

) + e

SB

ψ

(e

SB

) = Δq as in Section 5.1.2.

If ρ →∞, e

SB

→e

∗

.

As the principal is more risk averse, he ﬁnds it more interesting to get more insurance

by having a constant payoﬀ across states. In the limit of an inﬁnite risk aversion, the

agent’s rent is no longer viewed as costly and the ﬁrst-best eﬀort guarantees full insurance.

83

Poverty, Health Care and Moral Hazard

1- The problem of the utilitarian social welfare maximizer is

max

(p,δ)

(1 −π

0

+ δπ

0

)u(w −p) + (1 −δ)π

0

u

M

(w)

subject to

δπ

0

m = (1 −π

0

+ δπ

0

)p.

Hence, the ﬁrst order conditions hold:

u(w −p

∗

) −u

M

(w) = (m−p

∗

)u

(w −p

∗

) (1)

δ

∗

=

(1 −π

0

)p

∗

π

0

(m−p

∗

)

, (2)

(1) determines p

∗

and (2) determines δ

∗

.

Let g

1

(p) = u(w −p) −u

M

(w) and g

2

(p) = (m−p)u

(w −p).

Then g

1

(·) cuts only once g

2

(·) from above. Then, it is immediate to see that

dp

∗

dm

< 0,

dp

∗

dw

> 0,

dp

∗

dπ

0

= 0,

and from (2)

dδ

∗

dm

< 0,

dδ

∗

dw

> 0,

dδ

∗

dπ

0

< 0.

2- The problem becomes:

max

(p,δ)

(1 −π

1

+ δπ

1

)u(w −p) + (1 −δ)π

1

u

M

(q) −ψ

subject to

δπ

1

m = (1 −π

1

+ δπ

1

)p (3)

(1 −π

1

+ δπ

1

)u(w −p) + (1 −δ)π

1

u

M

(w) −ψ

≥ (1 −π

0

+ δπ

0

)u(w −p) + (1 −δ)π

0

u

M

(w). (4)

Suppose (4) is satisﬁed. Then, we obtain a solution like in 1 with π

1

instead of π

0

. It is

indeed the solution if (4) holds for the optimal solution p

∗

(π

1

), δ

∗

(π

1

), i.e., if

ψ ≤ Δπ(1 −δ

∗

(π

1

))(u(w −p

∗

(π

1

)) −u

M

(w)) = ψ

∗

.

84 SOLUTIONS

Then, the fact that poverty prevents treating every one is enough to create the incen-

tives for health care.

For ψ higher than ψ

∗

, the incentive constraint becomes binding. Substituting (3) in

(4) the optimal second best premium is such that

Δπ

1 −

p

SB

(π

1

)(1 −π

1

)

π

1

(m−p

SB

(π

1

))

u(w −p

SB

(π

1

)) −u

M

(w)

= ψ,

p

SB

(π

1

) (and therefore δ(π

1

)) decreases with ψ.

For ψ even higher, health care is given up.

3- Let u

11

= u(w − t

11

), u

12

= u(w − t

12

), u

21

= u(w − t

21

), u

22

= u(w − t

22

) and

ϕ(·) ≡ u

−1

(·).

Maximizing expected social welfare we have:

max

u

11

,u

12

,u

21

,u

22

(1 −π

1

)

2

u

11

+ π

1

(1 −π

1

)(u

12

+ u

21

) + π

2

1

u

22

−ψ

subject to

(1 −π

1

)u

11

+

2π

1

−1

2

(u

12

+ u

21

) −π

1

u

22

≥

ψ

2Δπ

, (5)

(2 −π

1

−π

0

)u

11

+ (π

1

+ π

0

−1)(u

12

+ u

21

) −(π

1

+ π

0

)u

22

≥

ψ

Δπ

(6)

(1 −π

1

)

2

ϕ(u

11

) + π

1

(1 −π

1

)(ϕ(u

12

) + ϕ(u

21

)) + π

2

1

ϕ(u

22

) ≤ w −π

1

m. (7)

Suppose that the constraint (6) is slack, and let λ

1

(resp. μ

1

) the multiplier of (5)

(resp. (7)). Then, the ﬁrst order conditions are

ϕ

(u

11

) =

1

μ

1

+

λ

1

μ(1 −π

1

)

ϕ

(u

12

) = ϕ

(u

21

) =

1

μ

1

+

λ

1

(2π

1

−1)

2π

1

(1 −π

1

)μ

1

ϕ

(u

22

) =

1

μ

1

−

λ

1

μ

1

π

1

,

from which u

12

= u

22

, u

11

> u

22

, u

11

> u

12

and u

12

> u

22

.

Note that (6) can be rewritten

(1 −π

1

)u

11

+

(2π

1

−1)

2

(u

12

+ u

21

) −π

1

u

22

≥

ψ

2Δπ

+

Δπ

2

(u

11

−u

12

+ u

22

−u

21

). (8)

Hence for ϕ(u) =

1

2

u

2

, u

11

−u

12

+u

22

−u

21

= 0 and the global incentive constraint is

satisﬁed.

85

In an individual contract we must solve:

max(1 −π

1

)u

1

+ π

1

u

2

u

1

−u

2

≥

ψ

Δπ

(λ)

(1 −π

1

)ψ(u

1

) + π

1

ψ(u

2

) ≤ w −π

1

m (μ),

hence

ψ

(u

1

) =

1

μ

+

λ

μ(1 −π

1

)

ψ

(u

2

) =

1

μ

−

λ

μπ

1

,

which is like having the constraints u

11

= u

12

and u

21

= u

22

in the previous problems.

This can only happen if λ

1

= 0 which is impossible when there is moral hazard.

Laﬀont, J.J. (2003a).

86 SOLUTIONS

Group Lending with Moral Hazard

1- Since r > pz, the only potentially valuable contract is a contract which induces eﬀort.

The bank solves the problem:

max

x≥0

¯ p(z −x) −r

¯ px −ψ ≥ px (1)

¯ px −ψ ≥ 0, (2)

where (1) is the incentive constraint and (2) the participation constraint. Clearly (1)

implies (2) and is binding so that

x =

ψ

¯ p −p

and the bank’s expected proﬁt is

¯ pz −

¯ pψ

¯ p −p

−r. (3)

If (3) is negative, then there is no lending. So, because the bank maximizes proﬁt, it

may not lend, when it is socially valuable to lend. We may indeed have

¯ pz −

¯ pψ

¯ p −p

−r < 0 < ¯ pz −r.

2- Eﬀort provision is a Nash Equilibrium if

¯ p(¯ px + (1 − ¯ p)y) −ψ ≥ p(¯ px + (1 − ¯ p)y). (4)

The bank’s expected proﬁt per entrepreneur is

¯ p(z −(¯ px + (1 − ¯ p)y)) −r.

From (4)

¯ px + (1 − ¯ p)y ≥

ψ

¯ p −p

;

hence

¯ p(z −(¯ px + (1 − ¯ p)y)) −r ≤ ¯ pz −r − ¯ p

ψ

¯ p −p

.

3- Constraint (3) in the text is implied by (1). Suppose that the local incentive constraint

is not binding. It can be rewritten:

¯ p

2

x + ¯ p(1 − ¯ p)y −ψ ≥ p

2

x + p(1 −p)y.

87

The bank’s expected proﬁt is

2¯ p(z −(¯ px + (1 − ¯ p)y)) −2r.

The solution of the maximization’s bank under constraint (1) is x =

ψ

¯ p

2

−p

2

, y = 0, i.e.,

the entrepreneurs are rewarded only if they both succeed. It remains to check that (2) is

satisﬁed by this solution, i.e.:

2(¯ p

2

−p¯ p) ·

ψ

¯ p

2

−p

2

≥ ψ

2

¯ p

¯ p + p

≥ 1 or ¯ p ≥ p

which holds.

The bank’s expected proﬁt per entrepreneur is

¯ pz −r −

¯ p

2

ψ

¯ p

2

−p

2

= ¯ pz −r −

¯ p

¯ p + p

·

¯ pψ

¯ p −p

greater than the expected projet in the optimal individual contract

¯ pz −r −

¯ pψ

¯ p −p

.

Group lending dominates. Under group lending, agents coordinate their choices of

eﬀort. When considering a deviation to zero eﬀort, an agent takes into account the

negative externality he exerts on the other since such a deviation makes it less likely that

the other agent receive a reward. Incentives provision is easier with group lending.

Laﬀont, J.J. and P. Rey (2003b).

88 SOLUTIONS

Incentives and Discovery

1- The principal solves

max u(q) + t

subject to

u(θ −q) −t ≥ 0,

hence the solution q =

θ

2

and t = u

θ

2

.

2- The principal solves

max

{(¯ q,

¯

t);(q,t)}

ν(u(¯ q) +

¯

t) + (1 −ν)(u(q) + t),

subject to

¯

U = u(

¯

θ − ¯ q) −

¯

t ≥ u(

¯

θ −q) −t

U = u(θ −q) −t ≥ u(θ − ¯ q) −

¯

t

ν(u(

¯

θ − ¯ q) −

¯

t) + (1 −ν)(u(θ −q) −t) ≥ 0.

From Chapter 2, we know that, under ex ante contracting with a risk-neutral agent,

the principal achieves the ﬁrst best

q =

θ

2

; ¯ q =

¯

θ

2

,

and that there are many pairs of transfers (t,

¯

t) or rents (U,

¯

U) which implement this

allocation.

3- Suppose on the contrary that the “usual” constraints, i.e., the

¯

θ-incentive constraint

and θ-participation constraint are binding. Then:

U = u(θ −q) −t = 0

¯

U = u(

¯

θ − ¯ q) −

¯

t = u(

¯

θ −q) −t

= u(θ −q) −t + u(

¯

θ −q) −u(θ −q)

= u(Δθ + θ −q) −u(θ −q).

When those constraints are binding, the optimization of the principal yields immedi-

ately:

u

(q) = u

(θ −q) +

ν

1 −ν

u

(θ −q) −u

(

¯

θ −q)

.

89

Since u

< 0, u

(θ −q) > u

(

¯

θ −q), hence u

(q) > u

(θ −q) hence q < θ −q or q <

θ

2

.

Therefore q < θ and

¯

U = u(Δθ + θ −q) −u(θ −q) < u(Δθ) −u(0) = u(Δθ),

so that the

¯

θ ex post participation constraint (2) is not satisﬁed, a contradiction with the

assumption that the optimal contract entails the postulated binding constraints.

4- If only the participation constraints are binding

t = u(θ −q);

¯

t = u(

¯

θ − ¯ q) −u(Δθ).

The optimal solution entails

q =

θ

2

and ¯ q =

¯

θ

2

.

These are the relevant constraints when Δθ > θ. Indeed, let us check that the incentive

constraints are then slack

u

¯

θ

2

−

¯

t = u(Δθ) > u

Δθ +

θ

2

−u

θ

2

,

from the concavity of u(·):

u

θ

2

−t = 0 > u(−Δθ) −u

¯

θ

2

,

since

u

¯

θ

2

> u(0) > u(−Δθ).

The principal’s expected welfare is

W(ν) = 2

νu

¯

θ

2

+ (1 −ν)u

θ

2

−νu(Δθ).

5- Note that for Δθ = θ or

¯

θ = 2θ

dW

dν

(ν) = 2

u(θ) −u

θ

2

−u(θ)

= u(θ) −2u

θ

2

< 0.

Note that

d

d

¯

θ

dW

dν

=

d

d

¯

θ

2

u

¯

θ

2

−u

θ

2

−u(Δθ)

= u

¯

θ

2

−u

(Δθ) < 0,

90 SOLUTIONS

iﬀ

¯

θ

2

< Δθ or

¯

θ > 2θ or Δθ > θ.

So

dW

dν

(ν) < 0 for all

¯

θ such that Δθ > θ.

Since W is decreasing in ν, the principal does not wish to encourage eﬀort but in the

contrary to discourage eﬀort. He solves the program:

max

(q,¯ q,t,

¯

t)

ν

0

(u(¯ q) −

¯

t) + (1 −ν

0

)(u(¯ q) −

¯

t),

subject to

u(θ −q) −t ≥ 0 (1)

u(

¯

θ − ¯ q) −

¯

t ≥ u(Δθ) (2)

ν

0

(u(

¯

θ − ¯ q) −

¯

t) + (1 −ν

0

)(u(θ −q) −t) ≥ ν

1

(u(

¯

θ − ¯ q) −

¯

t) + (1 −ν

1

)(u(θ −q) −t) −ψ. (3)

With (1) is binding, (2) and (3) become

u(

¯

θ − ¯ q) −

¯

t ≥ max

u(Δθ),

ψ

Δν

,

or, since u(Δθ) <

ψ

Δν

,

¯

t = u(

¯

θ − ¯ q) +

ψ

Δν

and t = u(θ −q).

Therefore, eﬀort is discouraged with the eﬃcient sharing of resources q =

θ

2

, ¯ q =

¯

θ

2

.

Laﬀont, J.J. (2003c).

91

III- MIXED MODELS

Political Economy of Regulation

1-

max

{t,C

1

,C

2

,e

1

,e

2

}

W = S

1

+ S

2

−(1 + λ)(t + C

1

+ C

2

) + U

subject to

t −

1

2

(e

2

1

+ e

2

2

) + γe

1

e

2

≥ 0

C

i

= β −e

i

i = 1, 2,

hence

e

1

= e

2

=

1

1 + γ

.

2- Let U = t −ψ(e

1

, e

2

) = t −ψ(β −C

1

, β −C

2

).

The incentive constraints are

¯

U =

¯

t −ψ(

¯

β −

¯

C

1

,

¯

β −

¯

C

2

) ≥ t −ψ(

¯

β −C

1

,

¯

β −C

2

)

U = t −ψ(β −C

1

, β −C

2

) ≥

¯

t −ψ(β −

¯

C

1

, β −

¯

C

2

),

or

¯

U ≥ U −Φ(C

1

, C

2

) (1)

U ≥

¯

U + Φ(

¯

C

1

,

¯

C

2

), (2)

with Φ(C

1

, C

2

) = ψ(

¯

β −C

1

,

¯

β −C

2

) −ψ(β −C

1

, β −C

2

).

The participation constraints are

¯

U ≥ 0 (3)

U ≥ 0. (4)

Expected welfare can be written

EW = S

1

+ S

2

−(1 + λ)

(1 −ν)

ψ(

¯

β −

¯

C

1

,

¯

β −

¯

C

2

) +

¯

C

1

+

¯

C

2

+ν(ψ(β −C

1

, β −C

2

) + C

1

+ C

2

)

−λ(νU + (1 −ν)

¯

U).

92 SOLUTIONS

Assuming that (2) and (3) are binding and optimizing we ﬁnd

e

1

= e

2

=

1

1 + γ

¯ e

1

= ¯ e

2

=

1

1 + γ

−

λ

1 + λ

ν

1 −ν

Δβ.

3- For a majority of non-shareholders we ﬁnd

e

1

= e

2

=

1

1 + γ

¯ e

1

= ¯ e

2

=

1

1 + γ

−Δβ.

For a majority of shareholders we ﬁnd

e

1

= e

2

=

1

1 + γ

¯ e

1

= ¯ e

2

=

1

1 + γ

−

(1 + λ)α −1

(1 + λ)α

ν

1 −ν

Δβ.

So a majority of non-stakeholders (stakeholders) distorts downward too much (too

little) eﬀort, because they undervalue (overvalue) rents with respect to the maximization

of social welfare. This democratic ﬂuctuation of policies is detrimental and opens the

possibility that decentralization of the regulation of each project in each region could

dominate this centralized regulation.

Laﬀont and Pouyet (2003).

93

Regulation of Quality

For the solution see Laﬀont and Tirole (1993), Chapter 4.

94 SOLUTIONS

Enforcement and Regulation

1- The regulator solves

max

(q,e,U)

S(q) + λp(q)q −(1 + λ)((β −e)q + F + ψ(e)) −λU

subject to

U = t −ψ(e) ≥ 0.

The solution is

S

(q

∗

) + λ(p

(q

∗

)q

∗

+ p(q

∗

)) = (1 + λ)(β −e

∗

)

ψ

(e

∗

) = q

∗

U = 0.

2- From the Revelation Principle we can restrict the analysis to the pair {(t, c); (

¯

t, ¯ c)}. It

is incentive compatible if

U = t −ψ(β −c) ≥

¯

t −ψ(β − ¯ c)

¯

U =

¯

t −ψ(

¯

β − ¯ c) ≥ t −ψ(

¯

β −c).

The ﬁrm’s ex ante participation constraint is

νU + (1 −ν)

¯

U ≥ 0.

From Chapter 2 we know that eﬃciency is achieved for adverse selection problems and

ex ante participation constraints when the agent is risk neutral. There are many transfers

(or rents) which implement the eﬃcient allocation.

3- The outcome of renegotiation entails eﬃcient levels of production ¯ q

∗

and eﬀort ¯ e

∗

since

renegotiation takes place under complete information when β =

¯

β, and the ﬁrm’s rent

level

¯

U

E

=

δ

ˆ

W(¯ q

∗

, ¯ e

∗

,

¯

β) + H

2λ

−

F

2

.

4- The ﬁrm’s new participation constraint is

νU + (1 −ν)π(c)

¯

U + (1 −ν)(1 −π(c))

¯

U

E

≥ 0.

95

The regulator solves now:

max

(q,e,¯ q,¯ e,c)

ν[

ˆ

W(q, e, β) −λU] + (1 −ν)π(c)[

ˆ

W(¯ q, ¯ e,

¯

β) −λ

¯

U]

+(1 −ν)(1 −π(c))[δW(¯ q

∗

, ¯ e

∗

,

¯

β) −λ

¯

U

E

] −(1 + λ)c,

under the participation and incentive constraints. We obtain immediately

q

E

= q

∗

e

E

= e

∗

¯ q

E

= ¯ q

∗

¯ e

E

= ¯ e

∗

(1 −ν)π

(c

E

) =

1 + λ

(1 −δ)

ˆ

W(¯ q

∗

, ¯ e

∗

,

¯

β)

.

Laﬀont, J.J. (2002).

96 SOLUTIONS

Regulation of a Risk Averse Firm

1- The participation constraints are

u(

¯

t −ψ(

¯

β −

¯

C)) ≥ 0

u(t −ψ(β −C)) ≥ 0.

The incentive constraints are

u(

¯

t −ψ(

¯

β −

¯

C)) ≥ u(t −ψ(

¯

β −C))

u(t −ψ(β −C)) ≥ u(

¯

t −ψ(β −

¯

C)).

Since u

**> 0 and u(0) = 0 they reduce to
**

¯ π =

¯

t −ψ(

¯

β −

¯

C) ≥ 0 (1)

π = t −ψ(β −C) ≥ 0 (2)

¯

t −ψ(

¯

β −

¯

C) ≥ t −ψ(

¯

β −C) (3)

t −ψ(β −C) ≥

¯

t −ψ(β −

¯

C). (4)

2- Social welfare adds the utility of consumers when they pay for the cost (t + C) from

distortionary taxes with a social cost of public funds 1 + λ, and the certainty equivalent

of the manager’s welfare.

As usual (1) and (4) are the relevant constraints and they can be rewritten

¯ π ≥ 0 (5)

π ≥ ¯ π + ψ(

¯

β −

¯

C) −ψ(β −

¯

C)

. .. .

H(

¯

C)

(6)

The regulator’s optimization program reduces to

max

{C,

¯

C,π,¯ π}

S −(1 + λ)

ν(π + ψ(β −C) + C) + (1 −ν)(¯ π + ψ(

¯

β −

¯

C) +

¯

C

+u

−1

(νu(π) + (1 −ν)u(¯ π))

subject to (5)-(6)

or

max

{C,

¯

C}

S −(1 + λ)

ν(H(

¯

C) + ψ(β −C) + C) + (1 −ν)(ψ(

¯

β −

¯

C) +

¯

C)

97

+u

−1

(νu(H(

¯

C))),

hence

ψ

(e) = 1

ψ

(¯ e) = 1 +

ν

1 −ν

H

(

¯

C) −

νu

(H(

¯

C))H

(

¯

C)

(1 −ν)(1 + λ)u

(u

−1

(νu(H(

¯

C)))

3- When the ﬁrm is risk neutral, u(x) = x. Then u

(c

˙

) = 1,

ψ

(e) = 1

ψ

(¯ e) = 1 +

ν

1 −ν

H

(

¯

C) −

H

(

¯

C)

(1 −ν)(1 + λ)

u(H(

¯

C)) > νu(H(

¯

C)) implies H(

¯

C) > u

−1

(νu(H(

¯

C))) or u

(H(

¯

C)) < u

(u

−1

(νu(H(

¯

C)))).

Thus, ψ

**(·) > 0 implies ¯ e is smaller when the ﬁrm is risk-neutral.
**

4-

u(x) =

1

ρ

(1 −e

−ρx

)

u

(H) = e

−ρH

ψ

(¯ e) = 1 +

ν

1 −ν

¸

1 −

e

−ρH

(1 + λ)(1 −ν(1 −e

−ρH(

¯

C)

))

H

.

If ρ = 0

ψ

(¯ e) = 1 +

λ

1 + λ

ν

1 −ν

H

(

¯

C)

= 1 −

λ

1 + λ

ν

1 −ν

Φ

(¯ e).

As ρ increases, ¯ e decreases if

e

−ρH

(1−ν(1−e

−ρH(

¯

C)

))

decreases with ρ (since H

< 0).

But this expression is equal to

1

(1 −ν)e

ρH(

¯

C)

+ ν

which is a decreasing function of ρ.

So eﬀort decreases as risk aversion increases. Indeed, the regulator perceives more neg-

atively the randomness of the ﬁrm’s rents and decreases eﬀort to decrease the information

rent.

98 SOLUTIONS

Technological versus Informational Advantage

1- Optimal regulation for ﬁrm 1:

max

(t

1

,C

1

)

S −(1 + λ)(t

1

+ C

1

) +

t

1

−

e

2

1

4

subject to

(PC) t

1

−

e

2

1

4

≥ 0.

t

1

is costly, therefore, PC will bind. Substituting PC into the objective function, the

problem becomes:

max

e

1

S −(1 + λ)

e

2

1

4

+ β

1

−e

1

**FOC with respect to e
**

1

: (1 + λ) −(1 + λ)

e

∗

1

2

= 0

e

∗

1

= 2. (1)

If β

1

= 2, then

C

1

= 2 −e

∗

1

= 0

t

1

=

e

∗2

1

4

= 1.

If β

1

= 3, then

C

1

= 3 −e

∗

1

= 1

t

1

=

e

∗2

1

4

= 1. (2)

Ex ante welfare (expected) is:

W

1

=

1

2

[S −λ −1] +

1

2

(S −λ −(1 + λ) −1)

or

W

1

= S −

3

2

(1 + λ). (3)

2- Optimal contract for ﬁrm 2. Regulator solves:

max

{¯ e

2

,e

2

}

1

2

S −(1 + λ)(

¯

t

2

+ 3k − ¯ e

2

) +

¯

t

2

−

¯ e

2

2

4

+

1

2

S −(1 + λ)(t

2

+ 3k −e

2

) +

t

2

−

e

2

2

4

.

99

subject to

t

2

−

e

2

2

4

≥ 0 (PC)

¯

t

2

−

¯ e

2

2

4

≥ 0 (PC)

¯

t

2

−

¯ e

2

2

4

≥ t

2

−

(e

2

+ k)

2

4

(IC)

t

2

−

e

2

2

4

≥

¯

t

2

−

(¯ e

2

−k)

2

4

(IC).

(PC) and (IC) bind so that

¯

t

2

=

¯ e

2

2

4

t

2

=

e

2

2

4

+

¯ e

2

2

4

−

(¯ e

2

−k)

2

4

.

Substituting into the objective function and maximizing with respect to e

2

, ¯ e

2

, we

obtain e

2

= 2, ¯ e

2

= 2 −

λ

1+λ

k and

¯

t

2

= 1 −

λ

1 + λ

k +

λ

2

4(1 + λ)

2

· k

2

. (4)

t

2

= 1 + k −

6λ + 2

8(1 + λ)

· k

2

. (5)

¯

C

2

= 3k − ¯ e

2

=

(3 + 4λ)k

(1 + λ)

−2

C

2

= 2k −e

2

= 2k −2. (6)

Substituting (4), (5) and (6) gives us the expected social welfare:

W

2

=

1

2

¸

λ(1 + 2λ)

4(1 + λ)

k

2

−(5 + 6λ)k

+ [S + (1 + λ)]. (7)

3- Condition on λ and k for selection of ﬁrm 2. From (7) and (3):

(W

2

−W

1

) ≥ 0 ⇔

λ(1 + 2λ)

8(1 + λ)

k

2

−

(5 + 6λ)

2

k +

5

2

(1 + λ) ≥ 0. (8)

k = 0 ⇒ W

2

−W

1

=

5

2

(1 + λ) > 0

k = 1 ⇒ W

2

−W

1

=

λ(1 + 2λ)

8(1 + λ)

−

5 + 6λ

2

+

5

2

(1 + λ)

=

λ(1 + 2λ)

8(1 + λ)

−

λ

2

< 0 (for λ > 0).

100 SOLUTIONS

Also,

d

dk

(W

2

−W

1

) =

λ(1 + 2λ)

4(1 + λ)

k −

5 + 6λ

2

< 0 for any k in [0, 1].

Since (W

2

−W

1

) is decreasing over the entire range k in [0, 1] and (W

2

−W

1

) > 0 for

k = 0 and (W

2

−W

1

) < 0 for k = 1 the smaller of the two roots of the quadratic equation

(8) gives the value of k, below which ﬁrm 2 is preferred, i.e.,

k <

5+6λ

2

−

26λ

2

+55λ+25

4

2

λ(1+2λ)

8(1+λ)

(9)

then choose ﬁrm 2.

4- Choosing ﬁrm in the interim stage. If the choice is made in the interim stage, W

1

is

either

W

1

= S −(1 + λ)(t

1

+ C

1

)

if β

1

= 2, or

W

1

= S −(1 + λ)(

¯

t

1

+

¯

C

1

)

if β

1

= 3.

From above: If

β

1

= 2, t

1

= 1, C

1

= 0 ⇒W

1

= S −(1 + λ)

β

1

= 3,

¯

t

1

= 1,

¯

C

1

= 1 ⇒W

1

= S −2(1 + λ).

Case 1: β

1

= 2

W

2

−W

1

=

λ(1 + 2λ)

8(1 + λ)

k

2

−

(5 + 6λ)

2

k + 2(1 + λ) (10)

k = 0 ⇒(W

2

−W

1

) > 0

k = 1 ⇒(W

2

−W

1

) < 0

d

dk

(W

2

−W

1

) =

λ(1 + 2λ)

4(1 + λ)

k −

5 + 6λ

2

< 0 for any k in (0, 1).

The smaller root of the quadratic equation is

R

1

=

5+6λ

2

−

28λ

2

+56λ+25

4

2

λ(1+2λ)

8(1+λ)

. (11)

101

If k < R

1

, then choose ﬁrm 2 at the interim stage when β

1

= 2 for ﬁrm 1.

Case 2: β

1

= 3.

Can be done in a similar manner as Case 1.

5- For any k, W

2

is now given by

W

2

=

1

2

¸

λ(1 + 2λ)

4(1 + λ)

k

2

−(5 + 6λ)k

+ [S + (1 + λ)] −

(1 + λ)(3 −k)

2

2

from (7).

So the optimal k will now be given by:

max

k

W

2

−

(1 + λ)(3 −k)

2

2

gives

k

∗

=

2(1 + λ)

7λ + 2λ

2

+ 4

. (12)

The optimal strategy depends upon comparing W

2

with W

1

:

W

2

−W

1

=

1

2

¸

λ(1 + 2λ)

4(1 + λ)

k

2

−(5 + 6λ)k

+[S+(1+λ)]−

(1 + λ)(3 −k)

2

−

¸

S −

3

2

(1 + λ)

.

or

W

2

−W

1

=

¸

−2λ

2

−7λ −4

8(1 + λ)

k

2

+

1

2

k −2(1 + λ) < 0 for any k in (0, 1).

Therefore, the optimal strategy is to always choose ﬁrm 1.

Note that W

1

does not depend on k, so any k in (0, 1) is optimal.

102 SOLUTIONS

Piracy and Optimal Pricing

1-

max

(q

0

,qc)

E

−e

−ρ(R(q

0

+αqc)−p

0

q

0

−˜ cqc

is equivalent to

max

(q

0

,qc)

−e

−ρ[R(q

0

+αqc)−p

0

q

0

−μqc−

1

2

ρq

2

c

σ

2

]

or

R

(q

0

+ αq

c

) = p

0

αR

(q

0

+ αq

c

) = μ + ρq

c

σ

2

q

c

(p

0

) =

αp

0

−μ

ρσ

2

. (1)

Since R(q

0

+ αq

c

) = a(q

0

+ αq

c

) −

1

2

b(q

0

+ αq

2

)

2

a −b(q

0

+ αq

c

) = p

0

q

0

(p

0

) =

a −p

0

b

−

α(αp

0

−μ)

ρσ

2

(2)

=

aρσ

2

+ αμb

bρσ

2

−

p

0

bρσ

2

(ρσ

2

+ α

2

).

The monopoly maximizes (p

0

−c)q

0

(p

0

), i.e.

(p

0

−c)

dq

0

dp

0

+ q

0

(p

0

) = 0

p

M

0

=

1

2

¸

aρσ

2

+ αμb

ρσ

2

+ α

2

b

+ c

. (3)

∂p

M

0

∂μ

=

1

2

αb

ρσ

2

+ α

2

b

> 0

∂p

M

0

∂c

=

1

2

> 0

∂p

M

0

∂α

=

1

2

¸

ρσ

2

b(μ −2aα) −2α

2

μb

2

(ρσ

2

+ α

2

b)

2

∂p

M

0

∂σ

2

=

1

2

¸

(ρσ

2

+ α

2

b)aρ −(aρσ

2

+ αμb)ρ

(ρσ

2

+ α

2

b)

2

103

∂p

M

0

∂σ

2

=

ραb(aα −μ)

(ρσ

2

+ α

2

b)

2

> 0 if aα > μ

< 0 if aα < μ.

∂p

M

0

∂ρ

=

αbσ

2

(aα −μ)

(ρσ

2

+ α

2

b)

2

< 0 if aα > μ

< 0 if aα < μ.

2- W = (p

0

−c)q

0

+ R(q

0

+ αq

c

) −p

0

q

0

−μq

c

−

1

2

ρq

2

c

σ

2

.

The optimal levels of q

0

and q

c

are obtained by maximizing W with respect to q

0

and

q

c

. By the Envelope Theorem

∂W

∂α

= q

c

R

(q

0

+ αq

c

) > 0

∂W

∂μ

= −q

c

< 0

∂W

∂σ

2

= −

1

2

ρq

2

c

∂W

∂c

= −q

0

< 0.

Welfare under monopoly is:

˜

W = (p

M

0

−c)q

M

0

+ a(q

M

0

+ αq

M

c

) −

1

2

b(q

M

0

+ αq

M

c

)

2

−p

M

0

q

M

0

−μq

M

c

−

1

2

ρσ

2

−(q

M

c

)

2

.

where q

M

0

, q

M

c

and p

M

0

are given by equations (2), (1) and (3) respectively. From the

envelop theorem

∂

˜

W

∂μ

= (p

M

0

−c)

∂q

M

0

∂μ

+

−q

M

0

∂p

0

∂μ

−q

M

c

. (4)

From (2) and (3):

∂q

M

0

∂μ

=

α

ρσ

2

∂p

M

0

∂μ

=

1

2

αb

ρσ

2

+ α

2

b

.

Substituting in (4):

∂

˜

W

∂μ

=

¸

4ρσ

2

+ 3α

2

b

4(ρσ

2

+ α

2

b)

μ

ρσ

2

−

[3(ρσ

2

+ α

2

b)c + aρσ

2

]α

4(ρσ

2

)(ρσ

2

+ α

2

b)

. (5)

104 SOLUTIONS

Given that μ = c

0

+ f,

∂

˜

W

∂μ

=

∂

˜

W

∂f

.

The optimal ﬁne is given by:

max

f

¸

˜

W −

1

2

δf

2

,

hence:

∂

˜

W

∂f

−δf = 0

or

4ρσ

2

+ 3α

2

b

4ρσ

2

(ρσ

2

+ α

2

b)

. .. .

||

A

f + Ac

0

−Bα −δf = 0

where

B =

¸

3(ρσ

2

+ α

2

b)c + aρσ

2

4ρσ

2

(ρσ

2

+ α

2

b)

or

f = max

¸

−Ac

0

+ Bα

A −δ

, 0

(6)

3- Two part tariﬀ (p

0

, F)

max

p

0

,A

(p

0

−c)q

0

+ F

subject to

R(q

0

+ αq

c

) −p

0

q

0

−μq

c

−

ρσ

2

q

2

c

2

−F ≥ 0 (PC).

Hence

q

0

=

a −p

0

b

−

α(αp

0

−μ)

ρσ

2

q

c

=

αp

0

−μ

ρσ

2

.

The participation constraint will bind (because raising F is desirable for the monop-

olist). Therefore:

F = a(q

0

+ αq

c

) −

b

2

(q

0

+ αq

c

)

2

−p

0

q

0

−μq

c

−

ρσ

2

q

2

c

2

. (7)

Substituting F, q

0

and q

c

in the objective function, the problem becomes

max

p

0

−cq

0

+ a

¸

a −p

0

b

−

1

2

b

a −p

0

b

2

−μ

αp

0

−μ

ρσ

2

−

ρσ

2

2

αp

0

−μ

ρσ

2

2

105

p

0

= c. (8)

4- Substituting p

0

= c in the expression for q

0

, q

c

and (7) gives us the lumpsum payment

F.

Let us now show that the Spence-Mirrlees property holds:

V (t

0

, q

0

, ρ) = max

qc

¸

R(q

0

+ αq

c

) −t

0

−μq

c

−

1

2

ρσ

2

q

2

c

.

Hence the F.O.C.: α(a −b(q

0

+ αq

c

)) −μ −ρσ

2

q

c

= 0

q

c

=

α(a −bq

0

) −μ

bα

2

+ ρσ

2

(9)

or

V (t

0

, q

0

, ρ) = a

q

0

+

α

2

(a −bq

0

) −αμ

bα

2

+ ρσ

2

−

b

2

q

0

+

α

2

(a −bq

0

) −αμ

bα

2

+ ρσ

2

2

−t

0

−

μα(a −bq

0

) −μ

2

bα

2

+ ρσ

2

−

1

2

ρσ

2

¸

α(a −bq

0

) −μ

bα

2

+ ρσ

2

2

∂V

∂t

0

= 1

∂V

∂q

0

= a −b(q

0

+ αq

c

) = a −bq

0

−b

α

2

(a −bq

0

) −αμ

bα

2

+ ρσ

2

.

∂

∂ρ

¸

∂V/∂q

0

∂V/∂t

0

= −σ

2

b(α

2

(a −bq

0

) −αμ)

(bα

2

+ ρσ

2

)

2

< 0.

V (t

0

, q

0

; ρ) = aq

0

−

1

2

bq

2

0

+

1

2

¸

(α(a −bq

0

) −μ)

2

bα

2

+ ρσ

2

−t

0

. (10)

The monopolist’s problem is:

max

{(q

0

,¯ q

0

),(t

0

,

¯

t

0

)}

ν[t

0

−cq

0

] + (1 −ν)[

¯

t

0

−c¯ q

0

]

subject to

V (

¯

t

0

, ¯ q

0

, ¯ ρ) ≥ 0 (PC)

V (t

0

, q

0

, ρ) ≥ 0 (PC)

V (

¯

t

0

, ¯ q

0

, ¯ ρ) ≥ V (t

0

, q

0

, ¯ ρ) (IC)

V (t

0

, q

0

, ρ) ≥ V (

¯

t

0

, ¯ q

0

, ρ) (IC).

106 SOLUTIONS

(PC) and (IC) will bind. Using (10) and this fact we get:

¯

t

0

= a¯ q

0

−

1

2

b¯ q

2

0

+

1

2

(α(a −b¯ q

0

) −μ)

2

bα

2

+ ¯ ρσ

2

, (11)

and

t

0

= aq

0

−

1

2

bq

2

0

+

1

2

¸

(α(a −bq

0

) −μ)

2

bα

2

+ ρσ

2

¸

−

1

2

[α(a −b¯ q

0

) −μ]

2

Δρσ

2

(bα

2

+ ¯ ρσ

2

)(bα

2

+ ρσ

2

)

. (12)

Substituting (11) and (12) in the objective function and maximizing w.r.t. q

0

and ¯ q

0

we get:

q

0

: a −bq

0

+

(−αb)

bα

2

+ ρσ

2

[α(a −bq

0

) −μ] −c = 0

¯ q

0

: +ν

(E)

. .. .

¸

α(a −b¯ q

0

) −μ

(bα

2

+ ¯ ρσ

2

)(bα

2

+ ρσ

2

)

(αb)Δρσ

2

+(1 −ν)

¸

a −b¯ q

0

−

αb

bα

2

+ ¯ ρσ

2

[α(a −b¯ q

0

) −μ]

−c

. .. .

(D)

= 0

q

0

is the same as under complete information case and ¯ q

0

is greater than that under

the complete information case, i.e., there is an upward distortion in the quantity sold to

the low type. (If the problem is concave, D will be a decreasing function of ¯ q

0

and since

E is positive we need ¯ q

0

to be greater than that under complete information case for the

above FOC to hold).

Crampes, C. and J.J. Laﬀont (2002)

107

Gathering Information before Signing a Contract

1- If the agent learns θ he accepts the contract only if t −θq is non-negative. His expected

utility is then

ν max(0, t −θq) + (1 −ν) max(0,

¯

t −

¯

θ¯ q) −ψ.

Accordingly the moral hazard constraint inducing no eﬀort in gathering information

is

ν(t −θq) + (1 −ν)(

¯

t −

¯

θ¯ q) ≥ ν max(0, t −θq) + (1 −ν) max(0,

¯

t −

¯

θ¯ q) −ψ. (1)

The optimization problems of the principal are formalized as shown below in the

solution of question 2.

2- Consider a contract in the class C

2

. Since

¯

t−

¯

θ¯ q < 0 the agent accepts only the contract

if θ = θ. The principal can mimic this contract by choosing

¯

t = ¯ q = 0 and the agent saves

the information cost.

So the principal can always mimic a contract in the class C

2

with a contract in the

class C

1

.

If t −θq ≥ 0 and

¯

t −

¯

θ¯ q ≥ 0, (1) is strictly satisﬁed. The principal must then solve the

classical problem

max

{(¯ q,

¯

t);(q,t)}

ν(S(q) −t) + (1 −ν)(S(¯ q) −

¯

t)

subject to

t −θq ≥

¯

t −θ¯ q (2)

¯

t −

¯

θ¯ q ≥ t −

¯

θq (3)

t −θq ≥ 0 (4)

¯

t −

¯

θ¯ q ≥ 0, (5)

which yields the second-best solution

S

(q

SB

) = θ; S

(¯ q

SB

) =

¯

θ +

ν

1 −ν

Δθ

t = θq

SB

+ Δθ¯ q

SB

;

¯

t =

¯

θ¯ q

SB

.

The principal’s utility level is V

SB

, which can be improved by lowering the e and ¯ e in

the same amount ε. It is easy to check the new contract still belong to C

1

.

108 SOLUTIONS

This solution is the one obtained when the agent is informed costlessly. So it cannot

be dominated by a solution in which the agent is informed at the cost ψ.

From the incentive constraint (2), t−θq ≥ 0 if

¯

t−

¯

θ¯ q ≥ 0. So, the only other interesting

case to consider is t −θq > 0;

¯

t −

¯

θ¯ q < 0.

The moral hazard constraint becomes

(1 −ν)(

¯

t −

¯

θ¯ q) ≥ −ψ.

The general optimization problem in the class C

1

is

max

{(q,t);(¯ q,

¯

t)}

ν(S(q) −t) + (1 −ν)(S(¯ q) −

¯

t)

subject to

t −θq ≥

¯

t −θ¯ q incentive constraint (6)

¯

t −

¯

θ¯ q ≥ t −

¯

θq incentive constraint (7)

ν(t −θq) + (1 −ν)(

¯

t −

¯

θ¯ q) ≥ 0 participation constraint (8)

ν(t −θq) + (1 −ν)(

¯

t −

¯

θ¯ q) ≥ ν max(0, t −θq) + (1 −ν) max(0,

¯

t −

¯

θ¯ q) −ψ (9)

moral hazard constraint.

For the maximization in the class C

2

, (8) and (9) are replaced by

ν max(0, t −θq) + (1 −ν) max(0,

¯

t −

¯

θ¯ q) −ψ ≥ 0 (10)

ν max(0, t −θq) + (1 −ν) max(0,

¯

t −

¯

θ¯ q) ≥ 0. (11)

The maximimand in the class C

2

is ν(S(q) −t).

3- Let us come back to the maximization in the class C

1

, with (9) replaced by (1 −ν)(

¯

t −

¯

θ¯ q) ≥ −ψ. If (8) is binding and not (9), we have a classical problem with an ex ante

participation constraint. We know that the principal can reach the ﬁrst best S

(q

FB

) = θ;

S

(¯ q

FB

) =

¯

θ with a zero expected rent

ν(t −θq

FB

) + (1 −ν)(

¯

t −

¯

θ¯ q

FB

) = 0.

This case is valid if (9) is not binding, i.e., if

(1 −ν)(

¯

t −

¯

θ¯ q

FB

) ≥ −ψ. (12)

109

The highest value of

¯

t −

¯

θ¯ q is obtained when the incentive constraint (6) is binding

t −θq

FB

=

¯

t −θ¯ q

FB

hence from (8)

¯

t −

¯

θ¯ q

FB

= −νΔθ¯ q

FB

.

Then (12) becomes ψ ≥ (1 −ν)νΔθ¯ q

FB

.

If (9) is binding and not (8)

¯

t =

¯

θ¯ q −

ψ

1 −ν

and from the incentive constraint

t = θq + Δθ¯ q −

ψ

1 −ν

.

The optimal quantities are the second-best ones and the welfare of the principal is

V

SB

+

ψ

1 −ν

.

This solution is valid if (4) is satisﬁed

ν

Δθ¯ q −

ψ

1 −ν

+ (1 −ν)

−

ψ

1 −ν

> 0

or

ψ ≤ ν(1 −ν)Δθ¯ q

SB

.

Finally, when (8) (9) are binding as well as (6) we obtain S

(q) = θ and

¯ q =

ψ

ν(1 −ν)Δθ

.

Summarizing we have:

E

T

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

ψ

q

FB

q

SB

ν(1 −ν)Δθ¯ q

SB

ν(1 −ν)Δθ¯ q

FB

The principal suﬀers from the ability of the agent to become informed about its type

before contracting. If ψ = 0 it is as if contracting was at the interim stage. When ψ

110 SOLUTIONS

is large enough the principal can achieve the ﬁrst-best and as ψ increase the principal’s

utility increases between V

SB

and V

FB

.

Cr´emer and Khalil (1992), Demski and Sappington (1986), Sappington (1984).

111

Better Information Structures and Incentives

1- Social welfare is

W = S −(1 + λ)(t + β −e) + U = S −(1 + λ)(ψ(e) + β −e) −λU.

The regulator’s program is

max

{(e,U);(¯ e,

¯

U)}

ν

S −(1 + λ)(β −e + ψ(e)) −λU

+(1−ν)

S −(1 + λ)(

¯

β − ¯ e + ψ(¯ e)) −λ

¯

U

subject to

U ≥

¯

U + Φ(¯ e)

¯

U ≥ U −Φ(e + Δβ)

U ≥ 0

¯

U ≥ 0,

with Φ(e) = ψ(e) −ψ(e −Δβ).

Hence, the solution is:

ψ

(e) = 1 ; ψ

(¯ e(ν)) = 1 −

λ

1 + λ

ν

1 −ν

Φ

(¯ e(ν))

U = Φ(¯ e) ;

¯

U = 0.

Furthermore there is shutdown of the ineﬃcient ﬁrm (with U = 0) if ν ≥ ν

∗

deﬁned

as the solution of

(1 −ν

∗

)

S −(1 + λ)

¯

β − ¯ e(ν

∗

) + ψ(¯ e(ν

∗

))

= λν

∗

Φ(¯ e(ν

∗

)).

2- The same analysis as in 1 can be made for each signal σ

i

with the posterior probabilities

ˆ ν

i

instead of ν, hence, for each i

ψ

(e

i

) = 1

ψ

(¯ e

i

) = 1 −

λ

1 + λ

·

ˆ ν

i

1 − ˆ ν

i

· Φ

(¯ e

i

). (1)

Let ¯ e

i

(ˆ ν

i

) = Z

ˆ ν

i

1−ˆ ν

i

the solution of (1).

When the regulator keeps both types of ﬁrms

E

σ

i

ˆ ν

i

= E

σ

i

E(1I

{β}

|σ

i

) = E1I

{

¯

β}

= ν

112 SOLUTIONS

where 1I

{β}

= 1 if β = β, 1I

{β}

= 0 if β =

¯

β, by the low of iterated expectations.

From Jensen’s inequality

E

σ

i

¯ e

i

(ˆ ν

i

) ≤ ¯ e(ν) if

ˆ

Z(ˆ ν

i

) ≡ Z

ˆ ν

i

1 − ˆ ν

i

,

is concave.

Since ψ

> 0, ψ

> 0, Z(·) is a decreasing function. h(ˆ ν

i

) ≡

ˆ ν

i

1−ˆ ν

i

is an increasing

convex function. Hence

ˆ

Z

= Z

h

2

+ Z

h

. Therefore

ˆ

Z is concave if Z

≤ 0. Note that

ˆ

Z is concave if ψ is quadratic or λ small enough.

So, the expected power of incentives decreases if the regulator has access to the infor-

mation structure I and there is never shutdown after σ

i

, i = 1, . . . , I.

Say that a signal is favorable (defavorable) if ˆ ν

i

> ν(ˆ ν

i

< ν). Then incentives decrease

(increase) for a favorable (defavorable) signal.

Now, if after each favorable signal ν

∗

i

> ν

∗

, i.e., the regulator shuts down the ineﬃcient

ﬁrm, the incentives increase (since ψ

(e

i

) = 1) when the ﬁrm is active. Since, on the

other hand incentives increase when the signal is unfavorable, incentives increase with the

availability of the information structure.

Boyer and Laﬀont (2003).

113

Competitive Pressure and Incentives

1- Consumers’ utility is

V = S(q

1

+ q

2

) + θq

1

q

2

−p

1

(q

1

, q

2

)q

1

−p

2

(q

1

, q

2

)q

2

−(1 + λ)

ˆ

t

where

ˆ

t is the gross transfer to the ﬁrm.

The monopoly’s utility is

U =

ˆ

t + p

1

(q

1

, q

2

)q

1

−(β −e)q

1

−ψ(e) ≡ t −ψ(e).

The fringe’s utility is

U

F

= p

2

(q

1

, q

2

)q

2

−cq

2

.

Social welfare is

V + U + U

F

= S(q

1

+ q

2

) + θq

1

q

2

+ λp

1

(q

1

, q

2

)q

1

−(1 + λ)((β −e)q

1

+ ψ(e)) −cq

2

−λU.

2- Optimal regulation is characterized by the solution of

max ν

S(q

1

+ q

2

) + θq

1

q

2

+ λp

1

(q

1

, q

2

)q

1

−(1 + λ)((β −e)q

1

+ ψ(e)) −cq

2

−λU

+(1 −ν)

S(¯ q

1

+ ¯ q

2

) + θ¯ q

1

¯ q

2

+ λp

1

(¯ q

1

, ¯ q

2

)¯ q

2

−(1 + λ)((

¯

β − ¯ e)¯ q

2

+ ψ(¯ e)) −c¯ q

2

−λ

¯

U

subject to

U ≥

¯

U + Φ(¯ e)

U ≥

¯

U −Φ(e + Δβ)

U ≥ 0

¯

U ≥ 0,

with Φ(¯ e) = ψ(¯ e) −ψ(¯ e −Δβ). Hence the ﬁrst-order conditions

ψ

(e) = q

1

ψ

(¯ e) = ¯ q

1

−

λ

1 + λ

ν

1 −ν

Φ

(¯ e)

S

+ θq

2

+ λ

∂p

1

∂q

1

(q

1

, q

2

)q

1

+ p

1

(q

1

, q

2

)

= (1 + λ)(β −e)

S

+ θq

1

+ λ

∂p

1

∂q

2

(q

1

, q

2

)q

1

= c

¯

S

+ θ¯ q

2

+ λ

∂p

1

∂¯ q

1

(¯ q

1

, ¯ q

2

)¯ q

1

+ p

1

(¯ q

1

, ¯ q

2

)

= (1 + λ)(

¯

β − ¯ e)

¯

S

+ θ¯ q

1

+ λ

∂p

1

∂q

2

(¯ q

1

, ¯ q

2

)¯ q

1

= c.

114 SOLUTIONS

3- We have two sets of 3 equations (one for β = β and one for β =

¯

β). Diﬀerentiating

these systems we have with the determinant D < 0, for both types

de

dc

=

1

D

S

+ θ + λ

∂

2

p

1

∂q

1

∂q

2

q

1

+

∂p

1

∂q

2

Sign

de

dc

= − Sign (S

+ θ + λ(S

q

1

+ S

+ θ)).

If goods are strategic substitutes (S

q

1

+ S

+ θ) < 0 then

de

dc

> 0.

If goods are strategic complement (S

q

1

+ S

**+ θ) > 0 and λ is large enough
**

de

dc

< 0.

4- For both types we have

de

dθ

=

1

D

¸

−q

1

S

+ θ + λ

∂

2

p

1

∂q

1

∂q

2

q

1

+

∂p

1

∂q

2

+ q

2

S

+ λ

∂

2

p

1

∂q

2

2

q

1

,

S

+ λ

∂

2

p

1

∂q

2

2

q

1

is negative from the second-order condition.

If goods are strategic complements

S

+ θ + λ

∂

2

p

1

∂q

1

∂q

2

q

1

+

∂p

1

∂q

2

> 0,

then

de

dθ

> 0.

If they are strategic substitutes, the substitution eﬀect may dominate and

de

dθ

< 0.

Boyer and Laﬀont ( 2003).

2

EXERCISES

I- ADVERSE SELECTION

Lending with adverse selection

There is a continuum of risk neutral borrowers with no personal wealth and limited liability. A proportion ν of borrowers (called type 1) have sure projects with return h for an investment of 1. A proportion 1 − ν of borrowers (called type 2) have (stochastically independent) projects with return h only with probability θ in (0, 1) and return 0 with probability 1 − θ, for an investment of 1. If he does not apply for a loan, the borrower has an outside opportunity utility level of u. There is a single risk neutral bank available for loans which has a ﬁnancing cost of r. The bank oﬀers contracts to maximize its expected proﬁt. For simplicity, we assume that all projects are socially valuable, i.e., θh > r + u 1- Explain why there is no loss of generality in considering the menus of contracts (r1 , P1 ), (r2 , P2 ) where Pi is the probability of obtaining a loan and ri is the repayment to the bank when the investment succeeds if the borrower announces that he is of type i. 2- Write the maximization program of the bank which chooses the menu {(r1 , P1 ); (r2 , P2 )} to maximize its expected proﬁt under the borrower’s participation and incentive constraints (for simplicity assume that if a borrower applies for a loan he loses his outside opportunity u). 3- Show that the optimal contract entails a non-random allocation of loans (i.e., Pi is either 0 or 1, i = 1, 2). Characterize the optimal contract. Discuss its properties. 3

4 EXERCISES Bundling with Asymmetric Information We consider a continuum of consumers who have the following independent willingnesses to pay for goods 1 and 2 and desire only one unit of each good. a consumer has an equal probability of having valuations θ − ε. In this exercise consider only deterministic pricing strategies. The two goods are sold by a monopolist who has a zero marginal cost for each of them. For each good. 3.Suppose that the monopolist can oﬀer only a bundle of the two goods at a price P B . 1. (Hint: Draw the table of the surpluses that the diﬀerent types of consumers derive from the optimal single prices with the associated proﬁts of the monopoly. 2.Determine the optimal pricing policy for each good and the associated revenue. . Exhibit a price for the bundle which attracts some consumers and makes more revenue from these consumers than the optimal single good prices).Show that there exist prices for the bundle of the goods which improve revenue even in the presence of the optimal single good prices. Determine the optimal P B and show conditions under which it raises more revenue than the optimal single good prices. θ or θ + ε (with θ > ε).

We assume that the poor have no endowment. Discuss. θ} a parameter describing how altruistic the rich in the South are. (a. There are nR rich in the South. Each agent of the North has an endowment of yN . A Determine the optimal level of aid qP when it is determined by a representative rich of the South. The preference parameter θ is private information of the rich in the South. Special case : v(·) = log(·) ¯ 3. Special case : v(·) = log(·). v < 0 where qN is the consumption.Suppose ﬁrst that the South lives in autarky and that the poor of the South are only helped by the rich in the South. each one with an endowment of yR . specifying aid conditional on the consumption a ¯ of the poor. Determine the optimal menu of contracts (¯. 2. Special case : v(·) = log(·) . The corresponding level of utility obtained by the rich will be called the status quo utility level U A (θ). v > 0. The consumption of the poor exerts a positive externality on the rich in the North who are nN in number. qP ). The utility function of a representative agent in the North is VN = qN + nP v(qP ). which maximizes the expected utility of the North under the incentive and participation constraints of the South. q P ). nP is the number of poor in the South and qP is the per capita consumption of the poor in the South.Assume now that the North does not know θ and let ν = P r(θ = θ). 1. The representative rich of the South has the utility function U = qR + nP θv(qP ) ¯ where qR is his consumption and θ in {θ. Show that if a is unconditional it does not aﬀect the level of aid.5 Incentives and aid We consider the problem of the North willing to aid the poor in the South. Given that the North must use the rich in the South as an intermediary (because they control the government) to help the poor we want to study how the incomplete information on θ aﬀects the optimal level of aid chosen by the North. Determine the optimal level of aid when a can be made conditional on the consumption level of the poor qP .Suppose ﬁrst that the North knows θ and brings to the South a level of aid nR a to increase the incentives of the rich in the South to help the poor.

the participation constraints are binding and social welfare can be reduced to ¯ S(νp + (1 − ν)¯) − (1 + λ)(νpθ + (1 − ν)¯θ) + νθ + (1 − ν)θ. calling for a downsizing of the public ﬁrm. t). p p¯ . θi can take one of two ¯ ¯ positive values {θ. θ} with ν = Pr(θi = θ) and 1 − ν = ¯ Pr(θi = θ). Let θi the outside utility level that worker i can obtain. or t ≥ pθ. Let us ﬁrst assume that p the values of outside opportunities are public knowledge. with S > 0 and S < 0. These outside opportunities are identically ¯ and independently distributed between workers on {θ. θ} with Δθ = θ − θ > 0. Total production of the public ﬁrm is then q = νp + (1 − ν)¯. ¯¯ If there is a cost 1 + λ of public funds. ¯ A new allocation of labor is characterized by the proportions p (resp. a probability to remain in the public ﬁrm and a payment (unconditional on remaining or not in the public ﬁrm). Assuming that workers are risk-neutral. In other words the government is under complete information. t for type θ and satisﬁes their participation constraints t + (1 − p)θ ≥ θ. If λ > 0.6 EXERCISES Downsizing a Public Firm We consider a public ﬁrm which is producing a public good with a continuum of workers of mass 1. or t ≥ pθ. t for type θ. type θ (resp. The workers accept to play the downsizing mechanism ¯ ¯ if the government pays them. Each worker produces one unit of public good. A mass q in [0. θ) a downsizing mechanism can be viewed as a pair of contracts {(p. t)} specifying for p ¯ ¯ each announcement θ or θ. p) of workers of ¯ who remain in the public ﬁrm. (¯. social welfare is equal to: S(νp + (1 − ν)¯) p ¯ −(1 + λ)(νt + (1 − ν)t) +ν(t + (1 − p)θ) ¯ +(1 − ν)(t + (1 − p)θ) ¯¯ Social value of the public good Social cost of transfers Welfare of workers. 1] of workers produces an output q which has social value S(q). New outside opportunities appear for workers. ¯ ¯ ¯ ¯¯ t + (1 − p)θ ≥ θ.

t). 1. It satisﬁes the participation constraint if ¯ ¯ t + (1 − p)θ ≥ θ ¯¯ t + (1 − p)θ ≥ θ. A downsizing mechanism {(p. ¯ if (1 + λ)θ > S (ν) > (1 + λ)θ. From now on.Determine the allocation of labor and the transfers that maximize expected social welfare.Discuss these constraints and show that one condition is redundant with the other three conditions. t) such that the downsizing mechanism {(p. t) that minimizes the social cost of transfers? 3. t). ¯ 2. (¯. p). Distinguish three cases according to the value of S (ν). ¯ ¯ ¯ ¯ b) For any implementable (p. 4. ¯ S (νp) = (1 + λ)θ and p = 0. ¯ p = 1 and p = 0.Is it possible to structure the payments in such a way that each type does not regret to have participated in the mechanism? (Hint: diﬀerentiate the payments between those who stay and those who leave) 5. t)} satisﬁes all the p ¯ incentive compatibility and participation constraints. if S (ν) < (1 + λ)θ. what is the pair of transfers (t.Suppose that workers diﬀer by the quality of their production in the public ﬁrm. p) can be implemented if there exists a ¯ pair of transfers (t. and not by the government. p) can be implemented if and only if p ≥ p. we suppose that the values of the outside opportunities are observed by the workers. (¯. A ¯ type θ worker produces ρ units of public good while a type θ worker still produces one . t)} is incentive compatible if and only if p ¯ ¯ ¯ t + (1 − p)θ ≥ t + (1 − p)θ ¯¯ ¯ ¯ t + (1 − p)θ ≥ t + (1 − p)θ. a) Show that (p.We will say that an allocation of labor (p.7 The social optimum is then characterized by: ¯ if S (ν) > (1 + λ)θ. ¯ p S (ν + (1 − ν)¯) = (1 + λ)θ and p = 1.

Characterize the allocation of labor which maximizes expected social welfare when ¯ ρθ > θ. .8 EXERCISES unit.

θ = θ.Now suppose that the worker with low disutility of eﬀort has an outside opportunity that gives him a utility level of V . θ < θ. The ﬁrm has the following utility function: U P = f (l) − t. but neither U nor θ are observed by him. The utility function of the worker is. θ} is the preference ¯ parameter known to the worker and u(·) in an increasing concave function. The proportion of workers with low disutility of eﬀort. Find the optimal contract. Compare this (Second-Best) solution to the First-Best. The agent’s optimal choice must satisfy the budget restriction c ≤ t. where c is consumption and l is labor supply. Characterize the solution to the ﬁrm’s problem which maximizes its utility function under the participation constraint of the worker. θ in {θ.Now assume that labor supply is observed by the employer (and is veriﬁable).9 Labor Contracts A ﬁrm designs a labor contract for a worker. 3. For Δθ = θ − θ. is ν. Call this solution the First-Best solution. l ¯SB · Δθ ≤ V ≤ t∗ Δθ (∗ = ﬁrst-best). 2. ¯∗ Δθ ≤ V ≤ l∗ Δθ and V ≥ l∗ Δθ. ¯ and (t. A 1. Characterize the ﬁrst-best and second-best (asymmetric information) solutions in this case. where f (l) is a decreasing returns to scale production function. Which are the l l binding constraints in each case and what type of distortion is needed? .Assume the ﬁrm knows θ. where t is the payment he receives from the ﬁrm. where (t. ¯ U = u(c) − θl. l) is the contract for l. ¯ is the ¯ contract chosen by the worker with disutility of eﬀort θ and (t. consider the cases in which ¯SB Δθ ≥ V (SB = second-best). Show that the First-Best solution is not imple¯ l) ¯ l) mentable. l). The ﬁrm can now oﬀer menus of contracts: (t. Take into account that the solution will depend on the ¯ size of V .

U SM = ˜ l(θ) Characterize the set of regulatory mechanisms which induce truthful revelation of θ.Suppose now that the government does not know θ which can take one of two values ¯ ¯ ˜ ˜ θ or θ with Δθ = θ − θ > 0. Consider the case in which w is small enough to justify the presence of a self-managed ﬁrm. What is the optimal allocation of labor? What happens if w is too large? Why is the size of the self-managed ﬁrm not optimal in general? 3. 2. (Assume that the ﬁrm is of negligible size with respect to the rest of the economy). where l is the number of workers (considered to be a continuous variable: l in R+ ) and θ > 0 is a productivity parameter known by the ﬁrm. Compute the per unit tax τ on the good produced by the ﬁrm that restores the optimal allocation of labor. so that w is the opportunity cost of labor in this economy.10 EXERCISES Control of a Self-Managed Firm Consider a ﬁrm that has a production function y = θl1/2 .Assume that ν = Pr(θ = θ). so that the ﬁrst-best is not implementable even if transfers are costless to the government. There are ﬁxed costs of production A. l Determine the optimal size (for workers) of the self-managed ﬁrm. t(θ)) which associates ˜ ˜ ˜ a labor input l(θ) and a transfer t(θ) to the ﬁrm’s announcement θ. . Let p be the price of the good produced competitively by the ﬁrm. 4. Suppose that the government wishes to maximize the expectation of U G = pθl1/2 − wl.Assume that the government knows θ. 5. Show that the solution of this problem does not satisfy the implementability condition. It uses a regulatory mechanism (l(θ). Derive the implementability condition on . The ﬁrm’s objective is now ˜ ˜ pθ(l(θ))1/2 + t(θ) − A . Show that we could also use a lump-sum tax T on the revenue of the self-managed ﬁrm to achieve the same objective. 1.Assume that the ﬁrm is managed by the workers and that its objective function is U SM = py − A .Let w be the competitive wage rate in the rest of the economy.

11 What is then the optimal regulatory mechanism. when the labor managed ﬁrm has a zero outside opportunity level of utility? .

4. 3. θ}.Show that an increase of μ corresponds to an improvement of information in the sense of Blackwell. 6. ν = Pr(θ = θ|σ = σ ). Furthermore. that is ν = Pr(θ = θ|σ = σ). 5.θ is now private information of the agent and ν = Pr(θ = θ). 2 Determine the updated principal’s beliefs about the eﬃciency of the agent.Show that nevertheless the expected utility of the principal increases with μ. S < 0) from this production and gives a transfer t to the agent. Characterize the optimal contract of the principal under incomplete information with interim participation constraints of the agent (suppose here and later that the value of the project is large enough so that the principal always wants to obtain a positive level of production).12 EXERCISES Information and Incentives An agent (natural monopoly) produces a quantity q of a good at a variable cost θq ¯ ¯ with θ in {θ. σ } with ¯ 1 ¯ ¯ μ = Pr(σ = σ|θ = θ) = Pr(σ = σ |θ = θ) ≥ . 1. The principal’s utility function is V = S(q) − t and the agent’s utility function is U = t − θq.Characterize the optimal contract of the principal under complete information about θ. .Suppose now that the principal has access to the information technology which allows him to receive a signal σ in {σ. 2. The principal gets an utility S(q)(S > 0. ¯ ¯ Characterize the optimal contract for each σ.Show that an increase of μ has two eﬀects on the principal’s expected utility. Δθ = θ − θ. the agent’s status quo utility payoﬀ is normalized at 0. the classical eﬀect (that we will call the Blackwell eﬀect) and an eﬀect due to the direct impact of μ on the expected utility of the principal conditional on σ.

. permits. 1 − ν) of type 1 (resp. citizens derive a beneﬁt u0 which depends on their valuation of time. Citizens are willing to bribe the oﬃcial to decrease of delays. . We assume that there is a proportion ν (resp.).13 The Bribing Game We consider an administration which is supposed to deliver with some ﬁxed delay a service to the citizens (passport.. With some additional eﬀort the oﬃcial can deliver the service with a shorter delay.. With the normal functioning of the administration. type 2) citizens ¯ who derive a beneﬁt from a decrease q of delay equal to θq(θq). Characterize the optimal bribing contract that the oﬃcial will oﬀer to the citizens. 2 Let us call q the decrease of delay that the oﬃcial can provide at a cost (q−Q) for him 2 where Q is a constant.

θ) = 0. Show that. 3. x) which maximizes the expectation of (1) under participation and incentive constraints of the ﬁrm.Optional. θ}. θ} and ν = Pr(θ = θ) is common knowledge.We assume in addition that Cθ < 0 and Cxθ < 0. θ). Cxx > 0 and θ is ¯ a parameter known only to the ﬁrm. if the regulator is not obliged to satisfy a participation constraint of the ﬁrm. x). The production cost of the ﬁrm is C(x. θ) ≥ 0 for all θ. ¯ characterize the decision rule x(θ). but creates a level of pollution x from its activities. . θ can take two values {θ. θ] with d dθ 1 − F (θ) f (θ) < 0. When the regulator must satisfy the ﬁrm’s participation constraint t − C(x. θ in {θ. D (x) ≥ 0. (t. 4. Compare with question 1. Cxxθ ≥ 0 and Cθθx ≤ 0. which maximizes W under complete inforˆ mation. θ) (1) where t is the transfer from the regulator to the ﬁrm and 1 + λ is the opportunity cost of social funds. with Cx < 0. he can implement x∗ (θ) by asking a transfer equal to the cost of damage up to a constant.Suppose now that the ﬁrm can refuse to participate (but in this case has a zero utility level) and assume that the regulator has (up to a constant) the following objective function W = −D(x) − (1 + λ)t + t − C(x. The damage created by the level of pollution x is D(x) with D (x) > 0. Determine the menu of contracts ¯¯ (t. 1.14 EXERCISES Regulation of Pollution We consider a ﬁrm which has a revenue R. 2.The level of pollution x∗ (θ) corresponding to the complete information optimum is characterized by D (x) + Cx (x. Same problem when θ is distributed according to the distribution F (θ) with ¯ density f (θ) on the interval [θ.

show that the optimal tax is negative. ¯ Determine q ∗ (θ).The government uses now a linear tax τ on the consumption of good 2 to control the monopoly. . where x is his consumption of good 1 (chosen as the numeraire) and q is his consumption of good 2 produced by the monopoly. θ}. The monopoly has a variable cost function C(q) = cq and must incur a ﬁxed cost K. Each consumer is characterized by his utility function. subject to ¯ ¯ νx(θ) + (1 − ν)x(θ) = x − c νq(θ) + (1 − ν)q(θ) − K. t)} the direct revelation mechanism which elicits the parameters θ from consumers. 3. of the monopoly’s proﬁts (with a weight σ larger than 1) and of taxes (with a weight λ > 0 such that σ ≥ λ).Optional.Write the optimization program of the monopoly when he is constrained to provide a non negative utility level to each consumer θ log q(θ) − t(θ) ≥ 0 ¯ for θ in {θ. ¯ ¯ The parameter θ can take two values θ or θ with θ − θ = 1 and let ν be the common knowledge proportion of type θ consumers.15 Taxation of a Monopoly We consider a monopoly facing a continuum [0.Let {(q. θ] with dθ 1−F (θ) < 0. θ log q + x. Consider the special f (θ) case of a uniform distribution on [2. Consumers have large resources in good 1. so that their behavior is always characterized by the ﬁrst-order conditions of their optimization programs. (¯. θ} which corresponds to an interior Pareto optimal allocation is the solution of: ¯ ¯ ¯ max ν [θ log q(θ) + x(θ)] + (1 − ν) θ log q(θ) + x(θ) . Assuming that the government maximizes a weighted average of consumers’ utility functions (with a weight 1). t). Questions 2 and 3 when θ is distributed according to the distribution F (θ) d ¯ with positive density f (θ) on the interval [θ. 1] of consumers. Characterize the truthful direct revelation mechanism which is optimal for the monopoly. θ in {θ. Characterize the direct revelation mechanisms which are truthful.Explain why the proﬁle of consumption q ∗ (θ). q ¯ 2. ¯ 1. x∗ . 4. 3] and c = 1 and obtain the associated nonlinear price. 5.

2 .Suppose now that consumers share the good and the payment. 2.16 EXERCISES Shared Information Goods. consumers have single peaked preferences and check it ex post). Assuming that demand is determined by the median consumer.Assuming ﬁrst that the monopolist can prevent the consumers to share the good. (hint 2: the distribution function G(·) of the median of three independent draws from the distribution F (·) is: G(x) = [F (x)]2 [3 − 2F (x)]). for the optimal pricing. Majority Voting and Optimal Pricing We consider a group of three consumers who share or not an information good sold by a monopolist who has a zero marginal cost. 1.Show that the expected proﬁt of the monopolist is higher when consumers share the good. 3. characterize the optimal pricing policy of the monopolist (hint 1: assume that. Let θi q− q2 −t the utility function of consumer i. 2] and private information of the consumers. 3 where q is the quantity of the good and t the payment. 2. The θi are independently drawn from the uniform distribution on [1. characterize the optimal pricing policy of the monopolist (under the simplifying assumption that almost all consumers must have a non-zero consumption level). i = 1.

Apply the Revelation Principle and characterize the truthful direct revelation mechanisms. θ}) suﬀers a disutility of working equal to ψ(θy). ψ (·) ≥ 0. The employer’s utility function is V = y − t. 2. (1 − ν)) equals the probability that the worker is of type θ ¯ (resp. ψ (·) > 0. ¯ For a production level y the worker of type θ (θ in {θ. 1. . a worker of type θ must work units of labor (with create a disutility of labor ψ( ). = θy) which If he receives a compensation t from the employer his net utility is U = t − ψ(θy). θ). Characterize the optimal contract of an employer who maximizes his expected utility under the incentive and interim participation constraint of the worker.17 Labor Contract with Adverse Selection We consider a principal-agent relationship in which the principal is an employer and the agent is a worker. In other words.Assume now that ν (resp.

and nothing otherwise. . where x is the share of production retained by the agent. Let ψ the cost of eﬀort e for the entrepreneur. With an investment normalized to 1 unit he will get an output of z with prob¯ ¯ ability P > 0 if he exerts an eﬀort level of e and with probability P > 0 (P > P ) if he ¯ exerts no eﬀort.18 EXERCISES II.MORAL HAZARD Lending with moral hazard We consider a cashless entrepreneur who wants to borrow and carry out the following project. ¯ Furthermore his status quo utility level is normalized to 0 and P z < r. A monopolistic bank with cost of fund r oﬀers a loan of 1 unit for a reimbursement of z − x when the project is successful. Determine the optimal loan contract of a bank which maximizes its expected proﬁt under the incentive and participation constraints of the entrepreneur.

Show that the project is ﬁnanced if and only if pH R ≥ B + I (1) 2. pH (R − P )) (0. the lender can catch the entrepreneur if the eﬀort is low and reverse the decision to obtain a high level of eﬀort. The expected payoﬀ matrix for this game is thus: e ¯ e Monitor pH P − m. pH (R − P )) (pH R − m. a. By spending m > 0. eL } of the entrepreneur: it is pH if eﬀort is high (eH ) and pL if e = eL . 1. Find the equilibrium strategies. Argue that the project is ﬁnanced if and only if: pH R ≥ m + I. Introduce a monitoring technology. b. This probability of success depends upon the eﬀort e in {eH . Not monitor (pH P. Show that the only equilibrium for P < R is in mixed strategies. There is a competitive loan market and the economy’s rate of interest is equal to 0.19 Moral Hazard and Monitoring An entrepreneur who has no cash and no assets wants to ﬁnance a project which costs I > 0. in this case the entrepreneur is punished and receives 0. A loan contract speciﬁes a given payment P if the income is R and 0 if the income is 0. 1 > pH > pL = 0. 0) .Suppose that (1) is not satisﬁed but pH R > I. The project yields R with probability p and 0 with probability 1 − p. The entrepreneur enjoys a private beneﬁt B > 0 if eﬀort is low and 0 if eﬀort is high. The lender and the entrepreneur choose simultaneously whether to monitor and whether to select a high eﬀort level. B) Assume m < pH R < B.

¯ 3. t. .As a benchmark. 5.Find the optimal contract oﬀered to the agent and determine the t. the agent can learn a signal σ ∈ {σ. Write the incentive constraints needed to have the risky project being chosen if and only if σ is observed.20 EXERCISES Inducing Information Learning We consider a principal-agent problem in which the risk-neutral principal wants to delegate to a cashless risk-neutral agent protected by limited liability. suppose that the principal uses the technology for information gathering himself. the risky project yields S with probability ¯ ν and S with probability 1 − ν. t0 and t which induce information learning. ¯ By incurring an eﬀort with cost ψ. Write the condition ¯ under which the learning of information is optimal. There is also ¯ a risky project. Show that the project is done only when σ is observed. t0 ) to incentivize the agent. t (resp. 2. with θ ∈] 1 . the acquisition of soft information about the quality of a risky project as well as the decision to engage or not in the risky project. The principal ¯ ¯ uses a contract (t. S) realizes.Suppose now that the agent decides to adopt or not the risky project. We will assume that ν S + (1 − ν)S = 0. σ } on the future realization of the risky project.Find the second-best rule followed by the principal.Write the incentive constraint needed to induce the agent to learn information. 1. 1] being interpreted as the σ ¯ 2 precision of the signal. ¯ 4. t) is the transfer received by the ¯ agent if he chooses the risky project and S (resp. t0 is the transfer he receives if he chooses the safe project. We will assume that Pr(¯ |S) = Pr(σ|S) = θ. There is a safe project which yields 0 to the principal with probability 1. In the absence of information.

Characterize the ﬁrst-best eﬀort. q]. The return to the principal q follows the distribution (F (·|e) with density f (·|e) on [0.Write the agent’s incentive and participation constraints when e is non observable by the principal. . 3. q ] such that the MLRP property ¯ ∂ ∂q fe (q|e) f (q|e) >0 holds. The principal beneﬁts from q − t(q) where t(q) is the transfers he makes to the agent. 2.21 Optimal Contract and Limited Liability We consider a risk-neutral principal who delegates a task to a risk-neutral agent protected by limited liability. Show that the optimal contract involves a cut-oﬀ q ∗ such that t(q) = 0 for q < q ∗ and t(q) = q for q > q ∗ . 1. Use the ﬁrst-order approach.Write the Lagrangian of the principal’s problem and optimize when the transfer t(q) belongs to [0. His eﬀort e is a continuous variable which costs him ˜ ψ(e) (ψ > 0. ψ > 0).

2 ˜ ˜ except that the probability of success writes as θ + e where θ is a random variable with zero mean. ˜ 1. 2.Suppose that the agent chooses his eﬀort before knowing the realization of θ.1.Suppose that the agent wants to guarantee a probability of success R. Show that ψ > 0 and ψ > 0 imply that the second best optimal eﬀort RSB < eSB . Conclude. Compute the second-best optimal eﬀort eSB . .22 EXERCISES The Value of Information under Moral Hazard We consider the simple model of contracting with limited liability of Section 5. but can ﬁne tune the choice of his eﬀort as a function of the realized state of nature that he observes.

23

Raising Liability Rule

We consider a lender-borrower relationship under moral hazard. The risk-neutral borrower wants to borrow I from a lender to ﬁnance a project with safe return V . The project may with probability 1 − e harm a third-party. The amount of safety care e costs ψ(e) to the borrower with (ψ > 0, ψ > 0, ψ > 0). The harm has value h. A ﬁnancial ¯ ¯ contract is a pair (t, t) where t (resp. t) is the borrower’s reimbursement to the bank if there is no (resp. one) environmental damage. 1- Suppose that e is observable. Compute the ﬁrst-best level of safety care and assume that the project is socially valuable when the interest rate is r. 2- Suppose now that e is not observable. We suppose that the bank is competitive and that the borrower has suﬃcient liability. Show that the ﬁrst-best is still implementable if the bank must reimburse h to the third-party in case of an accident. 3- Suppose that the bank must reimburse c < h to the third-party. We denote by w the initial assets of the borrower. Show that as w diminishes, the ﬁrst-best level of eﬀort can no longer be implemented. 4- Compute the second-best optimal level of eﬀort maximizing the borrower’s expected payoﬀ subject to the bank’s zero proﬁt constraint, the borrower’s incentive constraint and his limited liability constraint. 5- Show that raising the bank’s liability c leads to a lower expected welfare. 6- Show that this result no longer holds when the bank is a monopoly.

24

EXERCISES

Risk-Averse Principal and Moral Hazard

Suppose that a risk-averse principal delegates a task to a risk-neutral agent. With ¯ probability e (resp. 1 − e) the outcome is q (resp. q < q ). The risk-averse principal utility ¯ is v(q − t) where t is the agent’s transfer and v(·) is a CARA von Neumann-Morgenstern utility function. Eﬀort costs ψ(e) to the agent (ψ > 0, ψ > 0). 1- Suppose that e is not observable, compute the optimal contract with a risk-neutral agent. 2- Suppose that the agent is protected by limited liability. Compute the second-best level of eﬀort. 3- Analyze the two limiting cases where the principal is inﬁnitely risk-averse and where he is risk-neutral. Explain your ﬁndings.

25

Poverty, Health Care and Moral Hazard

We consider an economy composed of a continuum [0, 1] of identical agents. The income of an healthy agent is w. Each agent becomes (independently) sick with probability π0 , in which case he has only a survival income of w. Let δ the proportion of sick agents who beneﬁt from a medical treatment which costs m per capita: then, these agents recover their normal income w. Finally, the utility function of an healthy agent or of a sick agent who has received a treatment is u(·) with u > 0, u < 0. The utility function of a sick agent who has not been treated is uM (·) with uM > 0, uM < 0. 1- Let p the insurance premium that only healthy and treated sick agents can pay. We have potentially three types of agents: • a proportion 1 − π0 of healthy agents with utility level u(w − p), • a proportion δπ0 of treated sick agents with utility level u(w − p), • a proportion (1 − δ)π0 of non treated sick agents with utility level uM (w). Suppose income redistribution and price discrimination of insurance are not possible. Write thee optimization program of a utilitarian social welfare maximizer who must satisfy budget balance of the health sector. Write and interpret the ﬁrst order conditions of this program with respect to δ and p (assume an interior solution). Determine the comparative statics of the optimal solution with respect to m, w and π0 . Let W (π0 , p∗ (π0 ), δ ∗ (π0 )) denote optimal social welfare. 2- Suppose now that with a non observable non monetary cost of health care ψ any agent can decrease his probability of becoming sick from π0 to π1 , with Δπ = π0 − π1 . Determine the various regimes obtained when the expected social welfare is maximized under the budget constraint and the moral hazard constraint that agents ﬁnd valuable to spend ψ in order to decrease their probability of being sick. 3- We consider now pairs of agents who observe each other’s eﬀort of health care, and we assume that agents can perfectly coordinate their health care behavior. Assuming now that everybody is treated, let t11 the insurance premium of an healthy agent paired with a healthy agent, t12 (resp. t21 ) the one paid by a healthy (resp. sick) agent paired with a sick (resp. healthy) agent and t22 the one paid by a sick agent paired with a sick agent. Maximize the expected social welfare of a pair of agents under the incentive constraints that the pair prefers exerting two eﬀorts of health care rather than zero or one and under

Show that the solution obtained dominates the solution with individual contracts. .26 EXERCISES an expected budget balance equation (guess that the local incentive constraint is binding √ and that the other incentive constraint is satisﬁed for u(x) = 2x).

e. Denoting by x the entrepreneur’s share of output.27 Group Lending with Moral Hazard We consider two entrepreneurs each of whom can carry out a project with the following characteristics.Determine the optimal contract oﬀer to an entrepreneur when there is a single entrepreneur. z > 0 or 0. e. The probability of success is p for a high level ¯ ¯ of eﬀort e and p for no eﬀort with p > p > 0. Each entrepreneur has no wealth and must borrow to invest.There are now two entrepreneurs who do not observe each other’s eﬀort level. Funds are supplied by a proﬁt-maximizing bank which has a cost of funds r.We suppose now that entrepreneur observe each other’s eﬀort level and coordinate their eﬀort levels. Consider the program of the bank which implements eﬀort by both entrepreneurs with group lending contracts: max p2 (2z − 2x) + p(1 − p)(2z − 2y) − 2r ¯ ¯ ¯ s. 2¯2 x + 2¯(1 − p)y − 2ψ ≥ 2p2 x + 2p(1 − p)y p p ¯ p ¯ ¯ ≥ 2p¯x + p(1 − p)y + p(1 − p)y − ψ ≥ 0. his expected utility is • px − ψ if he exerts eﬀort e. The disutility of eﬀort is ψ for e and zero ¯ ¯ ¯ for e = 0. He can only repay his loan if he succeeds. ¯ ¯ • px if he exerts no eﬀort. (1) (2) (3) . The probability of success (i.t. Show that a group lending contract does not perform better than the individual contracts considered in question 1.. of getting z) depends in the entrepreneur’s eﬀort. Investing 1 generates a stochastic output which can take two values. which can take also two values e > 0 or 0. 2. Consider a group lending contract which induces eﬀort of both entrepreneur as a Nash equilibrium. ¯ 1. A group lending contract calls for a payment x when the partner succeeds and y when it fails. We assume that: pz − ψ > r > pz. 3.

y ≥ 0. . Find the optimal contract.28 EXERCISES x ≥ 0. Show that it is better than individual contracts for the bank. Explain why.

(1) (2) . Suppose that the principal oﬀers a contract to the agent before the agent’s search. determine the optimal contract oﬀered to the agent by a principal who maximizes his utility under the participation constraint of the agent u(θ − q) − t ≥ 0.Consider the regime where only the participation constraints (1) and (2) are binding (i.We assume now that the contract is imperfectly enforced. i.e. The principal’s utility function is u(q) + t with u > 0. and ¯ the incentive constraint of the “eﬃcient type” θ cannot be optimal (hint: assume the contrary).Under complete information about θ. he can exit the relationship with a quantity Δθ (resp. u < 0. Therefore. The agent’s utility function is u(θ − q) − t. the incentive constraints are slack).θ can take one of two values {θ. 0) of the resource. if he wants to maintain both types of agent in the relationship. with ¯ Δθ = θ − θ > 0 and is now private information of the agent. θ). 3. Show that the regime with the participation constraint of the “ineﬃcient type” θ. ν). ¯ 2.. u(0) = 0 and where q is the quantity of the resource obtained by the principal and t is the monetary payment made by the agent to the principal for being allowed to search. Characterize the optimal contract and denote W (ν) the principal’s expected welfare. Show that this is the relevant regime when Δθ > θ. When the agent discovers ¯ θ (resp. before the agent learns θ.29 Incentives and Discovery We consider a principal-agent relationship in which a principal delegates to an agent the search for a resource of unknown magnitude θ over which the principal has property rights. 4. Characterize the optimal contract that the principal oﬀers to the agent when he maximizes his expected utility under the agent’s incentive constraints and the agent’s ex ante participation constraint. θ} with respective probabilities (1 − ν. the principal is faced with the following ex post participation constraints: u(θ − q) − t ≥ 0 ¯ ¯ ¯ u(θ − q ) − t ≥ u(Δθ). 1.e.

Discussion. . Solve it when u(Δθ) < Δν . Show that W (ν) is decreasing in ν.30 EXERCISES 5.We assume now that by exerting an eﬀort which costs him ψ the agent increases the ¯ probability of a θ-discovery from ν0 to ν1 > ν0 with Δν = ν1 − ν0 . Write the program of a principal who selects a contract which discourages ψ eﬀort.

e2 ).Determine the optimal regulation under incomplete information when β is private information of the ﬁrm. ¯ Parameter β can take values in two values {β. i.. 1. The ﬁrm can provide an eﬀort ei in order to reduce the cost associated with project i. 3.MIXED MODELS Political Economy of Regulation We consider a ﬁrm which realizes two projects. e2 ) = (e2 + e2 ) + γe1 e2 . 2.Determine the optimal regulation under complete information. Social welfare is S1 + S2 − (1 + λ)(t + C1 + C2 ) + U.31 III. β} with ν = Pr(β = β). The cost reducing eﬀorts create a disutility to the ﬁrm equal to 1 ψ(e1 . Agents are of two types.e. 2 2 1 γ > 0.We assume now that the regulatory mechanism is determined by the political majority. A regulator reimburses the observable costs C1 and C2 and pays a net transfer t to the ﬁrm which has utility U = t − ψ(e1 . they share the rent of the regulated ﬁrm. Either they are stakeholders in the regulated ﬁrm. Let α the proportion of stakeholders. 2. of gross value S1 and S2 for the consumers. If α > 1/2 the majority belongs to stakeholders who choose regulation to maximize their objective function: α(S1 + S2 − (1 + λ)(t1 + C1 + t2 + C2 )) + U. The eﬃciency of the ﬁrm is the same for both projects. . i = 1. The cost function of the ﬁrm for project i is: Ci = β − ei where β is the eﬃciency parameter of the ﬁrm. Or they are non-stakeholders and do not share the rent.

Determine in each case the optimal regulation under incomplete information. .32 EXERCISES If α < 1/2 the majority belongs to non-stakeholders who choose regulation to maximize instead: (1 − α)(S1 + S2 − (1 + λ)(t1 + C1 + t2 + C2 )).

33 Regulation of Quality We consider a natural monopoly which has the cost function C = (β + s − e)q where q is the production level. 4. B. h. θ) = (A + ks − hθ)q − q 2 − 2 2 ¯ is a demand parameter known by where A. Write the maximization problem of the regulator under the incentive and participation constraints of the ﬁrm. We assume that the consumers get a gross surplus from the consumption of q units equal to B (ks − hθ)2 S(q. His outside opportunity utility level is normalized at zero. and. in addition. ψ > 0.We consider a utilitarian regulator who wants to maximize expected social welfare (V + U ). but not by the regulator.Assume that γ is distributed according to a uniform distribution. β} is a cost parameter. it implies that the net utility of the manager is U = t − ψ(e). s. 3. Let p(q) the inverse demand function.Show that the optimal regulation can be implemented with indirect mecanisms which are functions of a variable which aggregates the cost and quality dimensions. If ψ(e) (with ψ > 0. θ} the ﬁrm. s. k 2. θ) − p(q)q − (1 + λ)(t + C − p(q)q) where 1 + λ is the opportunity cost of public funds. .Study the dependence of the optimal regulatory mechanism with respect to the concern for quality. pays a transfer t net of cost and revenue. Show that the adverse selection problem with two parameters θ and β can be reduced to a one dimensional adverse selection problem with the parameter γ = β + h θ. 1. k are positive constants and θ in {θ. e is the eﬀort level of the manager. We assume that the regulator observes only the cost C and the ﬁrm’s revenue. The utility derived by consumers is then: V = S(q. ψ ≥ 0) is the disutility of eﬀort for the manager. s is the quality of the product ¯ and β in {β.

ψ > 0.34 EXERCISES Enforcement and Regulation We consider a natural monopoly which.Suppose now that the regulator cannot observe the eﬀort level e and does not know β. who pays a net transfer t = t + p(q)q − (β − e)q − F . he can oﬀer a contract to the ﬁrm before the latter discovers its type (see Figure 1 for the timing). S > 0. β} with ν = Pr(β = β) and e is a moral hazard variable which decreases cost. . Hence. To ﬁnance the transfer t. in addition to a ﬁxed cost F which is common knowledge. λ > 0. 2. Characterize the optimal solution. the participation constraint of the ﬁrm can be written: U = t − ψ(e) ≥ 0. but creates to the manager a disutility ψ(e) with ψ > 0. Utilitarian social welfare writes then: W = U + V = S(q) + λp(q)q − (1 + λ)((β − e)q + F + ψ(e)) − λU. has a variable cost function C = (β − e)q. ¯ where q is the production level. 1. So. Let p(·) the inverse demand function and t the transfer to the ﬁrm from the regulator. consumers’ net utility is ˆ V = S(q) − p(q)q − (1 + λ)t. we can make the accounting assumption that revenues and cost are incurred ˆ by the regulator. ψ ≥ 0. Consumers derive an utility S(q).Under complete information. β is an adverse selection parameter in {β. S < 0 from the consumption of the natural ˆ monopoly’s good. We assume that cost is ex post observable by the regulator as well as the price and the quantity. Accordingly. The ﬁrm’s net utility is: ˆ U = t + p(q)q − (β − e)q − F − ψ(e). the regulator maximizes social welfare under the ﬁrm’s participation constraint. the government must raise taxes with a cost of public funds 1 + λ. However.

The ﬁrm accepts or not the contract. Discuss. costly bargaining takes place under complete information. Therefore. This probability depends on the expenses c incurred to set up an enforcement mechanism. e. ¯ Assume that it is only the ineﬃcient type β which wants to renegotiate.Write the ﬁrm’s new participation constraint which takes into account that with probability 1 − π(c) there will be renegotiation. The ﬁrm discovers its type. π < 0 with the Inada conditions π (0) = ∞ and limc↔+∞ π(c) = 1. Production and transfer take place. To model this renegotiation we use the Nash bargaining solution but assume that renegotiation is costly (because it takes time say). Substitute the outcome of renegotiation into the regulator’s objective function and solve for the optimal contract and the optimal level of enforcement expenses c. We assume that π(0) = 0. q q q e Compute the outcome of renegotiation (¯E . the regulator is able to impose the implementation of the agreed upon contract. Its outcome solves: {¯. β) = S(¯) + λp(¯)¯ − (1 + λ)((β − e)¯ + F + ψ(¯)). The regulator is also penalized by a loss of reputation and obtains the utility level −H. c)} (where c = is average cost) which satisfy incentive constraints. e. (t. U E ). The status quo payoﬀs which obtain if the negotiation fails are determined as follows: The ﬁrm loses its ﬁxed cost F . with a probability π(c). However. β) − λU E + H) where δ in (0. c). π > 0. eE .¯. .U E } qe ¯ ¯ ˆ q ¯ ¯ ¯ max (U E + F )(δ W (¯. ¯ 3. C q Write the incentive constraints and the ﬁrm’s ex ante participation constraint. 1) models the cost of renegotiation and ¯ ¯q ˆ q ¯ ¯ W (¯. With probability 1 − π(c) the regulator is forced to accept a renegotiation. q ¯ ¯ 4.35 E Time The regulator oﬀers the regulatory contract. Figure 1 ¯¯ Explain why the regulator can restrict his contract to a pair {(t. Solve for the optimal contracts.We assume now that if the ﬁrm has a negative ex post utility (as ﬁrm β in question 3) it attempts to renegotiate its regulatory contract.

e and β are not observable by the regulator. 2.Consider the special case 1 u(x) = (1 − e−ρx ). C(β) = C. 4. where β in ¯ {β. ψ ≥ 0) for the ﬁrm’s manager. u < 0). ¯ ¯ ¯ ¯ with π = t − ψ(β − C) and π = t − ψ(β − C). ¯ ¯ ¯ ¯ 1. t(β) = t. ρ ¯ Show that the eﬀort level required from type β is decreasing in ρ. and has the utility function u(t − ψ(e)) with u > 0. The cost C is observed by the regulator who can give a transfer t to the ﬁrm with a cost of public funds 1 + λ. C(β) = C}. write the incentive and participation constraints of the ﬁrm. ¯ Interpret this social welfare function and. ψ > 0. The manager of the ﬁrm is risk averse. assuming that it is concave in (π. β} is an eﬃciency parameter and e is a level of eﬀort which creates a disutility ψ(e) (ψ > 0.For the revelation mechanism {t(β) = t.Compare the result of question 2 with the case where the ﬁrm’s manager is risk neutral. determine the optimal regulation under incomplete information when the regulator oﬀers a contract at the interim stage.36 EXERCISES Regulation of a Risk Averse Firm We consider a utilitarian regulator who wishes to realize a public project which has social value S. .Expected social welfare is deﬁned as ¯ ¯ π W = S − (1 + λ) ν(t + C) + (1 − ν)(t + C) + u−1 (νu(π) + (1 − ν)u(¯ )) . C = β − e. 3. but it is common knowledge that ν = Pr(β = β). A single ﬁrm can undertake the project for a cost. π ).

k and β1 such that ﬁrm 2 is chosen. k ≤ 1. characterize the values of λ. The outside opportunity utility levels are normalized to zero for both ﬁrms.Assuming that the regulator selects the ﬁrm at the ex ante stage.Assuming that the regulator oﬀers a contract only to ﬁrm 1. Ex ante β1 is unknown for everybody and drawn from {2. where β2 is also drawn ex ante (independently of β1 ) from {2. 4. Firm 2 has the cost function C2 = kβ2 − e2 . characterize the values of λ and k such that ﬁrm 2 is chosen. 3} with Pr(β2 = 2) = Pr(β2 = 3) = 1/2. Firm 1 has the cost function C1 = β1 − e1 where β1 is an eﬃciency parameter which is common knowledge and e1 is the manager’s eﬀort level which creates a disutility 1 e2 4 1 for him. the value of β2 is only observed by the manager of ﬁrm 2. what is the optimal regulation? 3.Suppose that k can be chosen ex ante at the cost (1+λ)(3−k) by the regulator. β2 observed by ﬁrm 2 interim Regulator oﬀers contracts Firms accept or reject Contracts are executed E t The regulator is utilitarian and can use transfers with a price of public funds 1 + λ. e2 is the manager’s eﬀort level which creates a disutility 1 e2 for him. This project can be realized by two diﬀerent ﬁrms run by two diﬀerent managers. 4 2 C1 and C2 are observed by the regulator. The timing of events is summarized below: ex ante β1 observed by all. at the interim stage. what is 2 the optimal strategy of the regulator at the ex ante stage? 2 . 1.37 Technological versus Informational Advantage We consider a project which has value S for consumers.Assuming that the regulator oﬀers only a contract to ﬁrm 2 at the interim stage. 3} with Pr(β1 = 2) = Pr(β1 = 3) = 1/2. However. 5. what is the optimal regulation? 2.Assuming that the regulator selects the ﬁrm at the interim stage. λ > 0.

For a social welfare function W which adds proﬁt to the certainty equivalent of the consumers’ utility level. Supposing that the cost of implementing the ﬁne f is 1 δf 2 . q0 . compute ˜ the demand functions q0 (p0 ). What is the optimal monopoly price pM ? Study the dependence of pM with respect to ρ. Let μ = c0 + f where c0 is the ∂μ reproducing cost and f an expected ﬁne. q 0 .Assuming that c is a normal random variable with mean μ and variance σ 2 . qc 2 Write the ﬁrm’s incentive constraints for the function V . ˜ ˜ Let W be social welfare under monopoly. 2 3. σ 2 . characterize the (constrained) optimal q0 and qc . qc (p0 ) of a ﬁrm maximizing its expected utility. The value for the ﬁrm of these purchases is R(q0 + αqc ) with α ∈ [0. Obtain ∂ W . . σ 2 . The ﬁrm has a utility function with constant absolute risk aversion so that his utility is c −e−ρ[R(q0 +αqc )−p0 q0 −˜qc ] . Study the comparative statics of W with respect to α. μ. determine the optimal ﬁne. Solve for the optimal direct revelation mechanism. c. t.Assume that ρ is private information of the ﬁrm and can take two values ρ or ρ with ¯ ρ > ρ and ν = Pr(ρ = ρ). 1. μ.What is the optimal two part tariﬀ of the monopolist? 4. α. 1]. 2 2. 0 0 Suppose 1 R(q0 + αqc ) = a(q0 + αqc ) − b(q0 + αqc )2 .38 EXERCISES Piracy and Optimal Pricing We consider a ﬁrm which can buy from a monopoly with marginal cost c software in ˜ quantity q0 at price p0 or pirate software in quantity qc at a random cost c which includes the illegal reproducing cost itself and a random ﬁne. Discuss. First show that the Spence-Mirrlees property holds for the surrogate utility function: 1 2 V (t0 . q0 ). ρ) = max R(q0 + αqc ) − t0 − μqc − ρσ 2 qc . c (Hint: use the envelop theorem). ¯ We will look for the optimal nonlinear price or the optimal direct revelation mechanism ¯¯ (t.

the agent’s utility is U = t − θq. We will consider two sets of contracts : those (class C1 ) which induce the agent to choose e = 0 and those (class C2 ) which induce the agent to choose e = 1. q).Determine the optimal contract in the class C1 . θ > θ. At date 2 the agent decides to learn θ at a cost ψ or not. either in the class C1 or in the class C2 of contracts.Show that a lower bound for the principal is obtained by constraining contracts to ¯ ¯q t − θq ≥ 0 .Write the optimization program of a principal who maximizes his expected utility under the incentive and participation constraints of the agent. Derive from this result that the interesting contracts to consider ¯ ¯q entail t − θ¯ ≤ 0. S < 0 and S(0) = 0. At date 4 the agent learns θ if he has decided not to learn it at date 2. Let t be the transfer from the principal to the agent . ¯¯ At date 1 the principal oﬀers a menu of contracts (t. 2. e is a moral hazard variable not observed by the principal. The principal’s utility is V = S(q) − t with S > 0. Let e be this decision : e = 1 if he learns. t − θ¯ ≥ 0. Show that the principal can always mimic a contract in the class C2 with a contract in the class C1 . (Distinguish three cases depending on whether the ex ante participation constraint is binding. q ). . (t. At date 5 the contract is executed. 3. At date 3 he accepts or not the contract. the moral hazard constraint is binding or both constraints are binding according to the value of ψ). θ}. 1. e = 0 if not. then.39 Gathering information before signing a contract We consider a principal agent problem in which the agent produces a quantity q of a ¯ ¯ good at a cost θq with θ in {θ.

Discuss the more general case where after some signals the regulator may want to shut down the high cost ﬁrm. σ2 . β} is a parameter which is privately known by the manager with ¯ Δβ = β − β > 0 and ν = Pr(β = β) is the common knowledge probability that the ﬁrm is a low cost ﬁrm. .40 EXERCISES Better Information Structures and Incentives We consider a natural monopoly which realizes a public project valued S at a cost ¯ C = β − e when β in {β. . . if after each σi . Characterize for each σi the optimal eﬀort level ei requested from the high cost ﬁrm ¯ νi ˆ νi ˆ and denote ei = Z 1−ˆi the solution ei as a function of the ratio 1−ˆi . ψ > 0. . 1. . σI } of signals and conditional probabilities Pr(σi |β) i = 1. . ψ ≥ 0. the expected power of incentives decreases when the regulator has access to the information structure J. i.Characterize the regulation which maximizes expected social welfare under the ﬁrm’s incentive and participation constraints (it is assumed that the regulatory contract is offered to the ﬁrm at the interim stage and that its status quo utility level is zero). e is the manager’s eﬀort which has a disutility ψ(e) with ψ > 0. 2. ˆ ˆ i = 1. the regulator wants to keep both types of ﬁrms. Accordingly the ﬁrm’s utility is U = t − ψ(e) where t is the net monetary transfer from the regulator to the ﬁrm and consumers’ welfare is V = S − (1 + λ)(t + β − e) where λ > 0 is the social cost of public funds. Social welfare is deﬁned as U + V . ¯ ¯ ν ν Show that. . νi = Pr(β = β|σi ). The cost C is observable by the regulator and reimbursed to the monopoly. . .e. . and if Z is concave. I. . I. .The regulator beneﬁts ex ante from an information structure J with a set Σ = {σ1 .. . Denote νi the posterior belief that the ﬁrm has a low cost after signal σi .

4. where U = t − ψ(e) is the utility of the monopoly where t is the net transfer (in addition to reimbursement of cost) from the regulator to the ﬁrm.Show that for a utilitarian social welfare maximizer the social welfare function can be written as S(q1 + q2 ) + θq1 q2 + λp1 (q1 .We say that the two goods are strategic complements (substitutes) if S q1 + S + θ > 0(< 0). ¯ ¯ where β in {β.Characterize the optimal regulation under asymmetric information when the monopoly’s status quo utility level is zero.Show that. The fringe’s cost function is C(q2 ) = cq2 where c is common knowledge. ψ ≥ 0. ψ > 0. is an adverse selection parameter (with ν = Pr(β = β)) and e is an eﬀort level which decreases cost with a disutility for the manager of ψ(e). β}. ψ > 0. Let p1 (q1 . β > β. the eﬀort of the regulated ﬁrm increases with the degree of substitution. 2. 3. If the products are strategic complements and λ is large enough. 1. then a reduction in c increases eﬀort for the regulated ﬁrm. The consumers’ utility function is S(q1 + q2 ) + θq1 q2 where θ is a measure of complementarity of the two goods. q2 )q1 − (1 + λ)(ψ(e) + (β − e)q1 ) − cq2 − λU.41 Competitive Pressure and Incentives We consider the case of a monopoly (producing good 1 in quantity q1 ) with a competitive fringe producing a diﬀerentiated good 2 in quantity q2 . The monopoly’s cost function is C1 = (β − e)q1 . Show that if the two goods are strategic substitutes a reduction in marginal cost c reduces eﬀort for the regulated ﬁrm. If the products are strong enough substitutes. if the two goods are strategic complements then eﬀort of the regulated ﬁrm decreases with an increase in the degree of substitution (θ decreases). . q2 ) the inverse demand function of good 1.

42 EXERCISES .

Type 2 obtains h with probability θ in (0. (1).It is a principal-agent problem with adverse selection. r ∈ IR+ } where P is the probability of receiving a loan and r is the repayment (in case of success).ADVERSE SELECTION Lending with Adverse Selection 1. we know that we can restrict the analysis to truthful direct revelation mechanisms. The agent has two possible types: Type 1 obtains h for sure for an investment of 1.e. The principal is the bank and the agent is the borrower. So we have A = {(P.e.r1 ). (1) (2) 2.The bank maximizes its expected proﬁt under the incentive and participation constraints.SOLUTIONS I. i. i. r2 )} which are incentive compatible : P1 (h − r1 ) ≥ P2 (h − r2 ) P2 θ(h − r2 ) ≥ P1 θ(h − r1 ). 1]. pairs {(P1 . the level of repayment if the project succeeds (if the project does not succeed the borrower has no revenue and no wealth). when a loan is granted.. 1) and zero with probability 1 − θ for an investment of 1..2). r) : P ∈ [0. r1 ).(P2 . solves {(P1 . The action space is the probability granting a loan and.t. (2) and P1 (h − r1 ) ≥ u P2 θ(h − r2 ) ≥ u 43 (3) (4) .r2 )} max νP1 (r1 − r) + (1 − ν)P2 (θr2 − r) s. From the Revelation Principle (Proposition 2. (P2 .

θP1 Substituting these expressions into the bank’s expected proﬁt we get νP1 (h − r) + (1 − ν)P2 (θh − r) − νu − (1 − ν)u. (1 − ν)(θh − r − u) < ν . 3. From (4) we have r2 = h − From (5) we have r1 = h − u θP2 if P2 = 0.e. we obtain a pooling contract with an expected proﬁt for the bank of ν h−r− u + (1 − ν)(θh − r − u). θ Type 1’s ex post information rent is h − r1 − u = Consider now case 2. The bank oﬀers a loan intended only for type 1. the expected revenue made with type 2 borrowers is less than the expected rent which must be given up to type 1’s borrowers because of the presence of type 2 borrowers.44 SOLUTIONS if it wishes to give a loan with positive probability to both types (case 1). The bank will obviously make this constraint binding. θ Since θh > r.. leave no information rent to type 1. Alternatively. It is only constrained by type 1’s participation constraint. (4) is binding and not (3). Case 2 is better for the bank than case 1 if and only if ν(h − r − u) > ν h − r − or u + (1 − ν)(θh − r − u) θ (1 − θ) u. (1) and (2) imply P1 (h − r1 ) = P2 (h − r2 ). θ (1−θ) u. Dividing (2) by θ. and provide a loan with probability one: r1 = h − u with an expected proﬁt for the bank ν(h − r − u). θ i.Let us ﬁrst consider case 1 where the bank contracts with both types of borrowers. 1). it might oﬀer a loan only accepted by type 1 (case 2). maximizing with respect to P1 and P2 gives P1 = P2 = 1 and r1 = r2 = h − u. (5) u . Since θ is in (0. θ Therefore.

θ) = P θ(h − r). Stiglitz and Weiss (1981). Laﬀont (2003). . The Spence-Mirrlees condition writes ∂U ∂θ ∂U ∂P ∂U ∂r = ∂U ∂θ (h − r)θ Pθ =0 and we obtain pooling because there is no way to screen apart both types. r. Indiﬀerences curves of the two types in the (P. r) plan do not cross. De Meza and Webb (1987).45 Why do we obtain a pooling contract if the principal wants both agents to participate? The utility function of the agent can be written U (P.

θ − ε} {θ − ε. θ − ε} {θ. Given the willingnesses to pay. we have six possible types of consumers with the following aggregate willingnesses to pay. Since the willingnesses to pay for the two goods are independent. θ − ε} Aggregate willingness to pay 2θ + 2ε 2θ + ε 2θ 2θ 2θ − ε 2θ − 2ε Again.Suppose now that the monopolist can oﬀer a price P B for a bundle made of one unit of each good. θ} {θ + ε. If p = θ + ε only 1/3 of the consumers buy and revenue is 1 (θ + ε). there is no way to screen types with either the quantities they consume or the probabilities of receiving the good.Since consumers want to consume only one unit and since only deterministic mechanisms are considered. if if θ ≤ 3ε θ > 3ε 2. for each good. the relevant posted prices for the bundle correspond to the willingnesses to . If p = θ − ε all consumers buy and revenue is θ − ε. θ + ε} {θ + ε. θ} {θ. If p = θ. Population 1 9 2 9 1 9 2 9 2 9 1 9 Preferences {θ + ε. the optimal single good price is (for each good): p∗ = θ =θ−ε with a total revenue for both goods R∗ = 4 θ 3 = 2(θ − ε) if if θ ≤ 3ε θ > 3ε. The seller can only post a price that a subset of consumers accept to pay. θ or θ + ε. 3 Since ε < θ. the three relevant prices that can be posted are θ − ε.46 SOLUTIONS Bundling with Asymmetric Information 1. 2 of the 3 3 consumers buy and revenue is 2 θ.

e. 5ε] θ ≥ 5ε. 5ε] θ ≥ 5ε. It is immediate to see that P B = 2θ = 2θ − ε = 2θ − 2ε with respective revenues worth − 2θ − 2ε 4 θ 3 16 θ 9 8 ε 9 if if if θ ≤ 2ε θ ∈ [2ε. P B = 2θ − ε provides more revenue than the optimal single good prices. if if if θ ≤ 2ε θ ∈ [2ε. Adams and Yellen (1976). A bundle price of 2θ − ε makes positive proﬁt since θ > ε and attracts all consumers except the (θ − ε. θ − ε} {θ. It also makes more proﬁt than the optimal single good prices when 8 4 (2θ − ε) > θ 9 9 i. Consider the case where θ < 3ε and p∗ = θ. 5ε].47 pay. θ} {θ + ε. θ > 2ε. Therefore. θ − ε} {θ − ε. θ − ε) types. θ} {θ. θ + ε} {θ + ε. . 3.For the optimal prices p∗ we can obtain the surplus made by each type of consumer and the associated revenue of the monopolist: p∗ = θ p∗ = θ − ε Surplus Proﬁt Surplus Proﬁt 2ε ε 0 ε 0 0 2θ 2θ 2θ θ θ 0 4ε 3ε 2ε 2ε ε 0 2(θ − ε) 2(θ − ε) 2(θ − ε) 2(θ − ε) 2(θ − ε) 2(θ − ε) Population 1 9 2 9 1 9 2 9 2 9 1 9 Preferences {θ + ε. for θ in [2ε. θ − ε} A successful bundle price must attract some consumers and make more proﬁt with them than with the optimal single good prices.

2. nP A A q + nP θv(qP ) = U A (θ).qP } A max qR + nP θv(qP ) A nR qR + nqP = nR yR + nR a with the same result for the consumption of the poor.The rich in the South solve A {qR .The rich of the South solve A {qR . Hence the program of the North: {qN . It is accepted by the South as long as it gets as much as in the autarky regime. The North oﬀers now a contract (qP .qP } A max qR + nP θv(qP ) subject to A nR q R + nP q P = n R y R hence A nR θv (qP ) = 1.qP a} max qN + nP v(qP ) subject to nR q R + n P q P = n R y R + nR a qR + nP θv(qP ) ≥ U A (θ) . A qP = nR θ.48 SOLUTIONS Incentives and Aid 1. (1) with a status quo utility level of yR − For v(·) = log(·). a) which speciﬁes the level of aid for a level of consumption of the poor. nR P U A (θ) = yR + nP θ(log nR θ − 1). Unconditional aid is ineﬀective in helping the poor.qR .

nR ¯ yR + a − Solving (3) and (4) for a and a. The problem of the principal becomes {¯. the rich’s utility is nP yR + a − qP + nP θv(qP ). For given a and qP . as usual. there is a potential problem of countervailing incentives. θ. 3. nR P Since the status quo utility level U A (θ) depends on the type. q P } yields q ¯ q (nN + nR θ)v (¯P ) = 1 (nN + nR θ)v (q P ) = 1 + ν ΔθnR v (q P ). (2) Comparing (1) and (2) we see that the poor in the South consume more. For v(·) = log(·). 1−ν Asymmetric information leads to a decrease in the poor’s consumption when the rich of the South are of type θ. as well as the participation constraint of type θ.To the previous program we must add incentive constraints. i. . have a low altruistic behavior.. which is binding. inserting in the objective function and maximizing ¯ with respect to {¯P . However we will guess that it is.¯P .a.49 nN q N = n N y N − nR a or (nN + nR θ)v (qP ) = 1.q P } aq max ν yN − nR nR a + nP v(¯P ) + (1 − ν) yN − ¯ q a + nP v(q P ) nN nN (3) (4) nP nP ¯ q ¯ qP + nP θv(¯P ) = yR + a − ¯ q + nP θv(q P ) nR nR P nP yR + a − q P + nP θv(q P ) = U A (θ). nR The incentive constraints are yR + a − nP q + nP θv(q P ) ≥ yR + a − ¯ nR P nP ¯ q yR + a − ¯ qP + nP θv(¯P ) ≥ yR + a − ¯ nR nP qP + nP θv(¯P ) ¯ q nR nP ¯ q + nP θv(q P ). qP = nN + nR θ instead of nR θ.e. the ¯ incentive constraint of the one who wants to lie.

50 SOLUTIONS With v(·) = log(·). nN + ΔθnR Azam and Laﬀont (2002). . a ≥ 0. a = 0 and the poor in the South get the ¯ same utility as under autarky. 1−ν ¯ It remains to check that the participation constraint of type θ is satisﬁed as well as type θ’s incentive constraint. we get: ¯ qP = nN + nR θ ¯ q P = nN + nR θ − ν ΔθnR . Note that the above solutions are in fact only valid as long as a ≥ 0. In fact when ν is too large. It happens when nN ≤ ν ΔθnR 1−ν or ν≥ nN .

1−ν λν ¯ S (ν + (1 − ν)¯) = (1 + λ)θ + p Δθ 1−ν and p = 1. 3. Now. the “good” type is the θ-type. p). (1) (2) (3) (4) Then. For any implementable pair (p. we have the ¯ ¯ following constraints ¯ ¯ ¯¯ (p − p)θ ≤ t − t ≤ (p − p)θ and (3) implies ¯ ¯¯ t ≥ pθ. If we have ν ¯ S (ν) > (1 + λ)θ + λ Δθ. ¯ ¯ ¯¯ The government minimizes the expected transfers νt + (1 − ν)t by choosing t = pθ and ¯ ¯ ¯ t = t + (p − p)θ = pθ + Δθp. p solves ¯ (5) . If we have instead ν ¯ Δθ > S (ν) > (1 + λ)θ (1 + λ)θ + λ 1−ν we get p = 1 and p = 0.Adding (1) and (2) implies p ≥ p. 2.51 Downsizing a Public Firm 1.Expected social welfare can be rewritten as: S(νp + (1 − ν)¯) − (1 + λ)νpθ − (1 + λ)(1 − ν)¯θ − λνΔθp p p¯ ¯ up to a constant. ¯ then. we are back to the familiar formulation and (2) + (3) imply (4).Let us rewrite the constraints as ¯ ¯ ¯ ¯¯ U = t − pθ ≥ t − pθ = U − pΔθ ¯ ¯ ¯ ¯ U = t − pθ ≥ t − pθ = U + pΔθ ¯ ¯ ¯¯ U = t − pθ ≥ 0 U = t − pθ ≥ 0.

ρS (ν + (1 − ν)ρ¯) = (1 + λ)θ + p 1−ν ν λ ¯ When ρθ < θ + 1+λ 1−ν Δθ. Then. Taking w = θ and w = θ ensures the ﬁrst point. ¯ As (5) shows. ¯¯ ¯ s ¯¯ (6) (7) A worker does not regret to have participated if his wage in the ﬁrm is larger than his outside opportunity and his severance payment is non-negative.Let w the wage if the worker remains in the ﬁrm and s his severance payment if he quits. 1+λ 1−ν the solution is as in question 3 except that (5) must ¯ λνΔθ . for low levels of downsizing. asymmetric information (Δθ) increases the level of downsizing and leaves it unchanged otherwise. ﬁnally S (ν) < (1 + λ)θ. from (6) and (7) ¯ ¯ s=0 ¯ and s = Δθ p ¯ > 0. 4. the ﬁrst-order conditions would call for p < p which is ¯ in conﬂict with the implementability condition p ≥ p. we have bunching at the ¯ optimal contract which solves ¯ max S((ν + (1 − ν)ρ)p) − (1 + λ)(νθ + (1 − ν)θ)p − λνΔθp p . 1−ν ν λ Δθ. Then. 1−p 5. By deﬁnition t = pw + (1 − p)s = pθ + Δθp ¯ ¯ t = pw + (1 − p)¯ = pθ.The incentive constraints remain unchanged so that the optimization program is now W = S(νp + (1 − ν)ρ¯) − (1 + λ)νpθ − (1 + λ)(1 − ν)¯θ − λνΔθp p p¯ ¯ ∂W ∂p ∂W ∂p ¯ ¯ As long as ρθ > θ + be replaced by = ν[S − (1 + λ)θ] ν ¯ = (1 − ν) ρS − (1 + λ)θ − λ Δθ .52 SOLUTIONS If. then p solves S (νp) = (1 + λ)θ and p = 0.

53 i. .e. ν + (1 − ν)ρ Jeon and Laﬀont (1999).. S ((ν + (1 − ν)ρ)p) = ¯ (1 + λ)(νθ + (1 − ν)θ) + λνΔθ .

t} So. i. t = ψ(u).(t.The ﬁrm’s problem is max f (l) − t subject to u(t) − θl ≥ 0. ¯ u (t∗ ) ¯ l 2. ¯ ¯l . for θ = θ: u(t∗ ) = θ l∗ θ f (l∗ ) = u (t∗ ) ¯ for θ = θ: ¯l ¯ u(t∗ ) = θ ¯∗ ¯ θ f (¯∗ ) = l .¯ l) ¯ max ν(f (l) − t) + (1 − ν)(f (¯ − t).¯ u l). Indeed.The ﬁrst-best allocation {(t∗ .54 SOLUTIONS Labor Contracts 1. Under asymmetric information. (t∗ . Then.l)} {(t. the optimal contract is the solution of ¯ l). The program can be rewritten as: {(¯. ¯∗ )} is not implementable. subject to ¯ u(t) − θ l ≥ u(t) − θ ¯ l ¯l ¯ u(t) − θ ¯ ≥ 0. l∗ ).(u. Suppose this menu were ¯ l oﬀered under asymmetric information. ¯∗ ). where we just consider the relevant incentive and participation constraints. the θ worker will select (t∗ . {l.e. Let ψ(·) be the inverse function of u(·).l)} max ν[f (l) − ψ(u)] + (1 − ν)[f (¯ − ψ(¯)] l) u u−θ l ≥ u−θ ¯ l ¯ u − θ ¯ ≥ 0. his utility is then ¯ u(t∗ ) − θ¯∗ = Δθ¯∗ > 0 l l instead of zero for (t∗ .. l∗ ).

l)} max ν(f (l) − ψ(u)) + (1 − ν)(f (¯ − ψ(¯)) l) u u − θl ≥ max(V. . the solution of question 2 is unchanged. u − θ¯ ¯ l) u − θ¯ ≥ 0. u(tSB ) = θlSB + Δθ ¯SB l u (tSB ) ¯ θ ν Δθ ¯l ¯ .(u. the employer’s program is now: {(¯.t. l l f (¯SB ) > l we ﬁnally get ¯SB < ¯∗ . ¯ ¯l If Δθ¯SB ≥ V .l} yields u(t∗ ) = θl∗ + V f (l∗ ) · u (t∗ ) = θ. ¯ l) yields f (lSB ) = θ . Under asymmetric information. since the rent of asymmetric l information is greater or equal to the outside opportunity level of utility. The two constraints are binding.55 l. f (¯SB ) = l + SB ) ¯ u (t 1 − ν u (tSB ) Since u (tSB ) < u (ψ(θ lSB )) f (lSB )u (ψ(θ lSB )) > θ = f (l∗ )u (ψ(θ l∗ )). which implies lSB < l∗ since u < 0 and f < 0. u(tSB ) = θ ¯SB . l l 3. Since ¯ θ ¯ u (t) SB SB ¯l ¯ ¯l f (¯ )u (ψ(θ ¯ )) > θ = f (¯∗ )u (ψ(θ ¯∗ )). Therefore u = θ ¯ and u = θ l + Δθ¯ Substituting ¯ ¯l these values in the employer’s objective function and maximizing with respect to (l.¯ u l).The ﬁrm’s problem is now: max f (l) − t s. u(t) − θl ≥ V {t.

¯ u l). u(t) = θ¯ ¯ u (t) θ λ f (l) = − Δθ . u (t) ν . if V becomes greater than Δθl∗ . u(t) = θ¯ ¯ u (t) 1 − ν If Δθ¯∗ < V < Δθl∗ .l)} max ν(f (l) − ψ(u)) + (1 − ν)(f (¯ − ψ(¯)) l) u ¯ u − θ¯ ≥ u − θl = V − Δθl ¯ ¯l u − θl = V u − θ¯ ≥ 0. the θ-incentive constraint is binding and the ﬁrm’s problem becomes: {(¯. t = θl + V u (t) ¯ θ ¯ ¯l.l)} max ¯l)) ν (f (l) − ψ(θl + V )) + (1 − ν)(f (¯ − ψ(θ¯ l) V − Δθ¯ ≥ 0 l (λ). It admits the solution: f (l) = θ l . u(t) = θl + Δθ¯ u (t) ¯ θ λ ¯l. The ﬁrm’s problem becomes: {(¯. l) .¯ u l). there is no reason to distort so much the production level l of the ineﬃcient type (the θ-incentive constraint and both participation constraints are binding). In the ﬁrst one.(u. t = θ¯ f (¯ = ¯ u (t) ¯ However. ¯ ¯l ¯ There exists two subcases.(u.¯ l} −V + Δθl ≥ 0 l) f (¯ = (λ) ¯ θ ¯l ¯ . ¯ f (¯ = l) + Δθ.56 SOLUTIONS l If Δθ¯SB < V ≤ ¯∗ Δθ. u(t) = θl + V. the θ-incentive constraint and both participation constraints are binding. there is no reason to distort the production level of the ineﬃcient l type and the solution is characterized by (only the participation constraints are binding) f (l) = θ . ¯l l) max ν(f (l) − ψ(θl + V )) + (1 − ν)(f (¯ − ψ(θ¯ + V )) {l.

then only the θ-incentive constraint and the θ-participation constraint l are binding and the solution is characterized by: f (l) = θ 1 − ν Δθ − . l) ¯ u (t) .57 l is increased to reduce the information rent to zero. u(t) = θ¯ + V − Δθl. Let ˆ l SB be deﬁned by SB l f (ˆ ) = SB SB 1 − ν Δθ θ . ¯SB ) u (t SB ¯ If V > Δθˆ . u(t) = θl + V ¯ u (t) ν u (t) ¯ θ ¯l ¯ f (¯ = . u(tSB ) = θ ˆ + Δθˆ − l l SB ¯ ν u (tSB ) u (t ) ¯ θ ¯l ¯ f (¯SB ) = l . u(tSB ) = θ ¯SB .

2 .58 SOLUTIONS Control of Self-Managed Firm 1. From now on we assume that w is small enough to justify the presence of the labor managed ﬁrm (LM ﬁrm). pθ2 . 3. ∗ To achieve eﬃciency we need to equate this term to τ =p− 4Aw . If instead we use a lump sum tax.The optimal allocation of labor is determined by equating the marginal product of labor to the wage w. .e.The optimal size of the self-managed ﬁrm is the solution to max i. the self-managed ﬁrm. 2 . 2 2w If w is small. LM pθ 1/2 −A = 2A pθ 2 . If w is larger than the per capita added value for LM the workers of the labor managed will quit to beneﬁt from the high wage elsewhere in the economy. the LM ﬁrm solves max hence = To achieve eﬃciency we need T = p2 θ 2 − A. which maximizes added value per capita and not proﬁt.The LM ﬁrm solves now max hence = 2A (p − τ )θ (p − τ )θ 1/2 −A .e. 4w 2(A + T ) pθ pθ 1/2 −A−T . 2 1 −1/2 pθ ∗ pθ = w or = . restricts the size of the ﬁrm with respect to the optimal size. i. 2.

The ﬁrm’s objective function is ∂ ∂θ U ( . Here. 2 or = ¯ p(νθ + (1 − ν)θ) 2w . . This ﬁrst-best allocation is not implementable.Incentive constraints are ¯ ¯ ¯ pθ ¯1/2 + t − A pθ ≥ ¯ pθ 1/2 1/2 +t−A (1) (2) +t−A ≥ ¯ pθ ¯1/2 + t − A . θ) = pθ −1/2 − A −1 − t ∂U/∂ 1 −1/2 > 0.( ¯. It is obtained from the program: ¯p max(νθ + (1 − ν)θ)¯ { } 1/2 −w .t). = p ∂U/∂t 2 −1 . the optimal solution entails bunching and does not exploit the information of the agent. However.59 4.t)} −1/2 )≥0 or ¯≤ . subject to (1)-(2) and ¯ ¯ pθ ¯1/2 + t − A ≥ 0 ¯ pθ 1/2 (3) (4) +t−A ≥ 0. 2w 2w ∗ i. t.The government’s program is ¯ {( . max ν(pθ 1/2 ¯ − w ) + (1 − ν)(pθ ¯1/2 − w ¯). and we could expect the usual constraints to be binding. the benevolent government is only interested in eﬃciency and would like to implement 2 ¯ 2 pθ ∗ ¯∗ = pθ = . there is a total conﬂict between the implementability condition and the proﬁle of allocations that the principal is interested in. ¯∗ > . Guesnerie and Laﬀont (1984). Therefore. ¯ Adding those two incentive constraints we get ¯ p(θ − θ)( ¯−1/2 − 5.e.

60 SOLUTIONS Information and Incentives 1{(t. ν(1 − μ) + (1 − ν)μ For each value of σ (σ and σ ). yields S (q ∗ ) = θ .¯). 1−ν 3ν = Pr(θ = θ|σ = σ) = νμ νμ + (1 − ν)(1 − μ) ν(1 − μ) ν = Pr(θ = θ|σ = σ ) = ¯ ¯ .q)} . the information structure is characterized by the matrix F = or F1 = ¯ Pr(σ = σ|θ = θ) Pr(σ = σ|θ = θ) ¯ Pr(σ = σ |θ = θ) Pr(σ = σ |θ = θ) ¯ ¯ μ 1−μ 1−μ μ .q)} max S(q) − t subject to t − θq ≥ 0 yields S (q) = θ 2¯q {(t. t = θq. ¯ 4. t = θq ∗ + Δθ¯ q ν ¯ ¯ ¯q S (¯) = θ + q Δθ .For any μ. ¯ where ν is replaced by ν and ν respectively. t = θ¯. the optimal contract is characterized as in question 2.(t. . max ¯ ν(S(q) − t) + (1 − ν)(S(¯) − t) q subject to ¯ t − θq ≥ t − θ¯ q ¯ ¯ ¯q t − θ¯ ≥ t − θq t − θq ≥ 0 ¯ ¯q t − θ¯ ≥ 0.

the utility of the decision-maker increases for an improvement of his information in the Blackwell sense. μ) − θ¯(¯ . q σ . σ)dG(θ|σ) dH(σ). μ) q ¯q ¯ q + Pr(θ = θ|σ = σ) S(¯(σ. μ) in the principal’s objective function. Take B= 1− Δμ 2μ−1 Δμ 2μ−1 Δμ 2μ−1 Δμ − 2μ−1 1 . θ. F 1 is an improvement in the sense of Blackwell if there exists a bistochastic matrix B such that F 2 = BF 1 . μ) ¯ ¯ ¯q σ + Pr(θ = θ|σ = σ ) S(¯(¯ . q σ q Therefore dW ∂W = dμ ∂μ + μ ﬁxed in F (q.The expected utility of the principal can be rewritten W = νμ[S(q ∗ ) − θq ∗ − Δθ¯(σ. μ)) − θ¯(¯ . The diﬀerence with a classical decision problem is that F (·) depends here directly on the precision μ of the signal and the signal σ. μ)) − θ¯(σ. μ)] q q σ +ν(1 − μ)[S(q ∗ ) − θq ∗ − Δθ¯(¯ . μ. μ)] ¯q σ +(1 − ν)μ[S(¯(¯ . μ) and Δθ¯(σ. μ)) ¯ q σ This expression can be written symbolically F (q. μ)) ¯ q σ + Pr(σ = σ ) Pr(θ = θ|σ = σ )(S(q ∗ ) − θq ∗ − Δθ¯(¯ .61 For μ − Δμ F2 = μ − Δμ 1 − μ + Δμ 1 − μ + Δμ μ − Δμ .θ.Let W (μ) denote the expected utility of the principal (with obvious notations): W (μ) = Pr(σ = σ) Pr(θ = θ|σ = σ)(S(q ∗ ) − θq ∗ − Δθ¯(σ. μ)]. because of the presence of the information rents Δθ¯(¯ . Here it is not necessarily the case. μ)] q ¯q +(1 − ν)(1 − μ)[S(¯(σ. In a classical statistical decision problem. μ) − θ¯(σ. σ θ|σ . 5.μ) σ θ|σ ∂F dG(θ|σ)dH(σ) . ∂μ New eﬀect Blackwell’s eﬀect 6.

μ)) > θ. μ)) − θ¯(σ. μ)] q σ q σ = (1 − ν) q (¯ .μ) ¯σ q (σ.62 SOLUTIONS By the Envelop Theorem we have: dW dμ ¯q q = −νΔθ¯(σ. μ)) − θ¯(¯ . ¯σ ¯ q σ . μ) > q (σ) and S (¯(¯ . 1−ν ¯ since q (¯ . μ) + (1 − ν)[S(¯(¯ . μ)] q ¯q σ +νΔθ¯(¯ . μ) − (1 − ν)[S(¯(σ.μ) ¯ ¯ S (q) − θ + ν Δθ dq > 0.

¯ ¯q As usual t = θq + u0 .63 The Bribing Game ¯¯ ¯ Let (t. q ) the contracts oﬀered where t (resp.¯). ν Agents who value more time are oﬀered a higher decrease of delay. ¯ The principal’s program is (q − Q)2 max ν t − ¯q {(t. This exercise ??? from Saha (2001). t) is the bribe requested for a decrease of delay q (resp.q)} 2 2 q ¯ (¯ − Q) + (1 − ν) t − 2 subject to θq − t ≥ θ¯ − t q ¯ ¯q ¯ ¯ θ¯ − t ≥ θq − t θq − t ≥ u0 ¯q ¯ θ¯ − t ≥ u0 . t = θ¯ − Δθq + u0 hence the solution ¯ q = Q+θ ¯ q = Q+θ− 1−ν Δθ. . q) and (t. q ).(t.

64 SOLUTIONS Regulation of Pollution 1. the solution is D (x) + (1 + λ)Cx (x. θ) − λU . θ). The program can be rewritten max{−D(x) − (1 + λ)C(x. 3.Under incomplete information the regulator maximizes expected social welfare under the incentive and participation constraint of the ﬁrm {(x. The participation constraint requires now the use of public money which has an opportunity cost of 1 + λ. If the ﬁrms must pay t(x) = D(x) + K it solves min{D(x) + C(x. t = C(x. θ) = 0. θ) = 0. θ). θ) − λU ) + (1 − ν) −D(¯) − (1 + λ)C(¯.t} subject to t − C(x. θ)} {x.U )} x ¯ max ¯ ν (−D(x) − (1 + λ)C(x. Let U = t − C(x. θ) + K} x (1) yielding (1). x x ¯ subject to .(¯. θ) − λU } subject to U ≥0 hence.U ). 2max{−D(x) − (1 + λ)t + t − C(x. θ) which includes the ﬁnancial cost. θ) ≥ 0.Let x∗ (θ) the solution of D (x) + Cx (x. So the marginal disutility of pollution is equal to the social marginal cost of depollution −(1 + λ)Cx (x.

θ)] = 0. . θ) − C(x. the solution x x ¯ D (¯) + (1 + λ)Cx (¯. The local incentive constraints are ˙ U (θ) = −Cθ (x(θ). ¯ ¯ where we use the notation U = t − C(x. θ) (−μ(θ)) x(θ) ≥ 0 ˙ U (θ) ≥ 0 for all θ. Depollution is more costly because of the information rent which must be given up to elicit the information. θ) − λU (θ)} dF (θ) θ subject to ˙ U (θ) = −Cθ (x(θ). θ) ¯ ¯ U ≥ U + C(x.Let U (θ) = t(θ) − C(x(θ). θ) = 0 D (x) + (1 + λ)Cx (x. U = t − C(¯. θ) − C(¯. x(θ)).65 ¯ x ¯ x U ≥ U + C(¯. θ)x(θ) = 0 and (6) follows from the Envelope Theorem. ˙ ˙ The regulator’s optimization program is ¯ θ {x(·). θ)x(θ) ≥ 0 or x ≥ 0 since Cxθ < 0. θ) the level of utility of the truthful ﬁrm when it is faced with the DRM (t(θ). The second order condition is −Cxθ (x(θ). the participation constraint reduces to U (θ) ≥ 0. θ) U ≥ 0 ¯ U ≥ 0. x is greater than the full information level. ν ¯ Since D ≥ 0. θ). θ) x(θ) ≥ 0. θ). ˙ since the ﬁrst-order condition of incentive compatibility is ˙ ˙ t(θ) − Cx (x(θ). θ) − C(x.U (·)} (6) max {−D(x(θ)) − (1 + λ)C(x(θ). Cxx > 0 and Cxθ < 0. Since Cθ < 0. Hence. θ) + 1−ν ¯ λ[Cx (x. θ). x ¯ (2) (3) (4) (5) ¯ ¯ ¯ As usual since Cθ < 0. θ) − Cx (x. θ is the eﬃcient type and U = 0 and U = C(x. 4.

Cxxθ ≥ 0. From the Pontryagin condition μ(θ) = − ˙ hence ¯ μ(θ) − μ(θ) = λ(1 − F (θ)) or μ(θ) = −λ(1 − F (θ)).e. See Groves and Loeb (1975). θ) = 0. θ). A ˙ suﬃcient condition is d dθ 1 − F (θ) f (θ) ≤0 . and since Cθx < 0 and D ≥ 0. an downward distortion of pollution for all the other types.66 SOLUTIONS The Hamiltonian is H = (−D(x) − (1 + λ)C(x. Maximizing H with respect to x we obtain ﬁnally D (x(θ)) + (1 + λ)Cx (x(θ). θ) − λU )f (θ) − μCθ (x.. i. It remains to check that the second order condition is satisﬁed. x(θ) ≥ 0. θ) − λ(1 − F (θ)) Cθx (x(θ). e . ¯ ¯ Since there is no constraint at θ = θ. Aspremont and G´rard-Varet (1979). the transversality condition implies μ(θ) = 0. Cθθx < 0. f (θ) ∂H = λf (θ) ∂U ¯ There is no distortion at θ = θ. Cxx > 0.

¯ ¯ {(q(θ).q).The monopoly’s maximization program is then ¯q {(t. the monopoly’s problem becomes ¯q {(t.. q(θ) = θ c and ¯ θ ¯ q(θ) = . ¯ ¯ 3.e.x(θ))} max ¯ ¯ ¯ ν[θ log q(θ) + x(θ)] + (1 − ν)[θ log q(θ) + x(θ)] subject to ¯ ¯ ¯ νx(θ) + (1 − ν)x(θ) = x − c[νq(θ) + (1 − ν)q(θ)] − K i.Because utility functions are quasi-linear all interior Pareto optima are obtained by maximizing the utilitarian criterion under the resource constraint of the economy. Incentive constraints are then θ log q − t ≥ θ log q − t ¯ ¯ ¯ ¯ θ log q − t ≥ θ log q − t.¯)} (1) (2) max ¯ q ν(t − cq) + (1 − ν)(t − c¯) subject to (1)-(2) and θ log q − t ≥ 0 ¯ θ log q − t ≥ 0.When τ is the tax.e.(t. we obtain ¯ ¯ θ (1 − ν) Δθ θ q= ¯ .x(θ)).(t. Hence t = θ log q and t = θ log q − Δθ log q. i. q= − .67 Taxation of a Monopoly 1.q).¯)} max ¯ q ν(t − cq) + (1 − ν)(t − c¯) subject to θ log q − t − τ q ≥ 0 .(q(θ).A θ-consumer’s utility function writes θ log q + x∗ − t where x∗ is a ﬁxed parameter and t is the payment made to the monopoly. ¯ ¯ (3) (4) ¯ ¯ ¯ We can expect (3) and (2) to be binding. c 2. c c ν c 4. Inserting in the objective function of the monopoly and maximizing with respect to q and q ..

5. The derivative with respect to τ is ¯ dq (1 − σ)(1 − ν)Δθ σνθ σ(1 − ν)θ d¯ q + + ν(λτ − σ(c + τ )) + + (1 − ν)(λτ − σ(c + τ )) q q dτ q ¯ dτ +(λ − σ)(νq + (1 − ν)¯). Also τ is bounded below by −c (see (5)).¯} q hence q= ¯ ¯ θ (1 − ν) Δθ θ . (7) (8) . By the envelope theorem. q= − . ˜ The government’s problem is then ¯ max (1 − ν)Δθ log q + σ ν(θ log q − (c + τ )q) + (1 − ν)(θ log q − (c + τ )¯ − Δθ log q) ¯ q τ q +λ(νq + (1 − ν)¯)τ subject to (5). q dτ q dτ (6) For λ > 0 and σ ≥ λ. (6) is negative for τ > 0. The interior solution is then: τ =− (λ − σ)(νq + (1 − ν)¯) + q dq dq 1−ν Δθ dτ q d¯ q λ ν dτ + (1 − ν) dτ < 0. The maximand can be rewritten ¯ ¯ q Δθ(1 − σ)(1 − ν) log q + σνθ log q + σ(1 − ν)θ log q + (λτ − σ(c + τ ))(νq + (1 − ν)¯). c+τ c+τ ν c+τ (5) Everything happens as if the marginal cost was c = c + τ instead of c.68 SOLUTIONS ¯ θ log q − t − τ q ≥ θ log q − t − τ q ¯ ¯ ¯ ¯ where we just write the relevant constraints or ¯ max ν θ log q − (c + τ )q + (1 − ν) θ log q − (c + τ )¯ − Δθ log q ¯ q {q. q Using (5) this expression becomes dq (1 − ν)Δθ d¯ q + νλτ + (1 − ν)λτ + (λ − σ)(νq + (1 − ν)¯).Let U (θ) = θ log q(θ) − t(θ) be the utility of a θ-consumer. the incentive constraints are ˙ U (θ) = log q(θ) q(θ) ≥ 0 ˙ for all θ.

2q 3 q + 2 2 2 T (·) is concave.U (·)} ¯ θ max (t(θ) − cq(θ))dF (θ) = θ θ (θ log q(θ) − cq(θ) − U (θ))dF (θ) subject to (7)-(8) and U (θ) ≥ 0. F (θ) = θ − 2 and c = 1: q(θ) = 2θ − 3 θ SB (θ) = θ− 1−F (θ) f (θ) c or θ(q) = 3+q 2 t(θ) = θ log q(θ) − θ log q(u)du 3 q + 2 2 log q − 2 q 3 +2 2 T (q) = t(θ(q)) = log q(u)du dT dq 2 dT dq 2 1 3 1 1 = + + log q − log 2 2q 2 2 3+a = − 2 . .69 The monopoly’s maximization program is ¯ θ {t(·). 3]. Maximizing with respect to q(·) we obtain ﬁnally θ 1 − F (θ) 1 =c+ q(θ) f (θ) q(θ) or q with no distortion at the top only. In the case of a uniform distribution on [2. The Hamiltonian is H = (θ log q(θ) − cq(θ) − U (θ))f (θ) + μ(θ) log q(θ).q(·). ∂U (9) ¯ ¯ ¯ Integrating (9) between θ and θ we get μ(θ)−μ(θ) = F (θ)−F (θ) or μ(θ) = −(1−F (θ)). ¯ ¯ Since U is increasing. From the Pontryagin principle μ(θ) = − ˙ ∂H = f (θ). There is a discount for buying more (see ﬁgure below). there is no constraint at θ = θ so that μ(θ) = 0.

70 SOLUTIONS T 3 2 • • q ∗ (θ) q SB (θ) 1 • E θ 1 2 3 .

25.The monopolist’s optimization program is: 2 {q(·). q2 − T (q) 2 . Indeed V (θ. Then π I = 2 and π II ≈ 9. 3. ˙ yielding q(θ) = θ − 1−G(θ) g(θ) and an expected proﬁt for the monopolist π II 3 = 2 2 1 θ− 1 − G(θ) dG(θ).Let G(θ) the cumulative distribution function of the median of the types and g(θ) its density function. ˙ yielding q(θ) = 2(θ − 1) and an expected proﬁt for the monopolist πI = 3 2 2 1 [2(θ − 1)]2 dθ = 2. The monopolist’s program is: 2 {q(·).U (·)} max 3 θq(θ) − 1 q(θ)2 − U (θ) dG(θ) 2 ˙ U (θ) = q(θ) q(θ) ≥ 0. As q(θ)2 U (θ) = θq(θ) − − t(θ) 2 θ(q) q2 − T (q) = t(θ(q)) = θ(q)q − q(u)du. q) = −θ (q) < 0. Majority Voting and Optimal Pricing 1. and the majority rule yields the choice of the median agent.U (·)} max 3 1 θq(θ) − q(θ)2 − U (θ) dθ 2 subject to ˙ U (θ) = q(θ) q(θ) ≥ 0. g(θ) Given that G(θ) = (5 − 2θ)(θ − 1)2 . 2.G(θ) = (θ − 1)2 (5 − 2θ). 2 1 Then each agent’s utility function is single-peaked. q) = θq − yields Vqq (θ. Let θ(q) be its inverse function. we can check that q(θ) is increasing in θ.71 Shared Information Goods.

2. y ∈ IR+ and t ∈ IR} .72 SOLUTIONS Labor Contract with Adverse Selection 1. Hence ¯y ¯y ¯ t = ψ(θ¯) and t = ψ(θy) + ψ(θ¯) − ψ(θ¯). From the Revelation Principle. t. (3) (4) We can expect the participation constraint of the ineﬃcient type (4) and the incentive constraint of the eﬃcient type (1) to be binding.The principal’s optimization program is: {(y.Since the observables of the principal are y and t A = {y. we can restrict the analysis to the pair of contracts (y. The agent’s incentive constraints are y ¯ ¯ t − ψ(θy) ≥ t − ψ(θ¯) y ¯y ¯ ¯ t − ψ(θ¯) ≥ t − ψ(θy). ψ ( ¯) = ψ (θ¯) = ¯ − ¯ θ 1−ν θ The marginal disutility of labor is equated to its marginal productivity for the eﬃcient type. y Substituting these solutions in the principal’s objective function and maximizing with ¯ respect to y. t).t)} y¯ (1) (2) max ν[y − t] + (1 − ν)[¯ − t] y ¯ subject to (1)-(2) and t − ψ(θy) ≥ 0 ¯y ¯ t − ψ(θ¯) ≥ 0. t)(¯. (2) becomes: ¯ ¯y 0 ≥ −ψ(θy) + ψ(θy) + ψ(θ¯) − ψ(θ¯) y or 0≥y ¯ θ ¯ θ ¯ θ ψ (θ¯)dθ − y y θ ψ (θy)dθ . (3) is implied by (4) and (1). y we obtain: 1 ψ ( ) = ψ (θy) = .(¯. It is distorted downwards for the ineﬃcient type.t). θ ¯ 1 ν θψ ( ¯) − θψ ( ) ¯y .

11 that the problem is well behaved and the constraints are binding as we guessed.73 or ¯ θ ¯ θ y 0 ≥ (¯ − y) y θ ψ (θ¯)dθ − y y θ θ y ¯ ψ (θy)dydθ. Hart (1983a). ∂ ∂θ ∂U ∂y ∂U ∂t = ∂ (−θψ (θy)) = −ψ − θyψ < 0. ∂θ and we know from Section 2. Hart and Holmstr¨m (1987). (5) From the optimal solution > ¯ implies y > y hence (5) holds. If U = (t − ψ(θy)). ¯ Indeed the Spence-Mirrlees condition writes here. o . Chari (1983). Green and Kahn (1983).

p−p ¯ Hence. pψ . the optimal individual contract entails a loan which induces eﬀort if pz ≥ ψ + r + ¯ Otherwise. p−p ¯ .74 SOLUTIONS II. p−p ¯ The bank’s expected proﬁt is pz − ¯ pψ ¯ − r. From (2) the expected rent of the ¯ entrepreneur is: pψ R= . there is no lending.MORAL HAZARD Lending with Moral Hazard The optimization problem of the bank is: ¯ max p(z − x) − r x≥0 subject to px − ψ ≥ px ¯ px − ψ ≥ 0. ¯ (1) (2) ψ The incentive constraint (1) implies x = p−p .

satisﬁes the entrepreneur’s participation constraint and ensures non negative proﬁt. i.. it is worth ﬁnancing the project only if one can design a contract which induces eﬀort eH . i.e. It is immediate to check that there is no pure strategy equilibrium.Since pL = 0. But then the eﬀort is always high since the lender always monitors. From (1). Let μ1 = Pr(e = eH ).e. The lender must be indiﬀerent between monitoring or not.e. μ1 [pH P − m] + (1 − μ1 )(pH R − m) = μ1 pH P or m = (1 − μ1 )pH R. Let us compute the mixed strategy equilibrium. The participation constraint of the entrepreneur is pH (R − P ) ≥ 0. The entrepreneur must be indiﬀerent between the two eﬀort levels. P = R − B pH (1) (2) (3) and from (3) pH R ≥ B + I. μ2 pH (R − P ) + (1 − μ2 )pH (R − P ) = μ2 × 0 + (1 − μ2 ) · B or pH (R − P ) = (1 − μ2 )B. μ2 = Pr (Monitor).pH R > I but pH R < B + I and m < pH R. Lending occurs if pH R − m ≥ I. So the bank can now choose a best repayment of P = R. . i. The mixed strategy equilibm rium entails μ2 = 1 and μ1 = 1 − pH R . 2.75 Moral Hazard and Monitoring 1. pH (R − P ) ≥ B pH (R − P ) ≥ 0 pH P ≥ I.

(2θ − 1)ν(1 − ν) .The agent chooses the risky project if he learns σ when ¯ ¯ (1 − θ)(1 − ν)t θν t + ≥ t0 .But.Ex ante. If the principal induces the agent to learn information then the agent’s decision rule is optimal. (1 − θ)ν + θ(1 − ν) (1 − θ)ν + θ(1 − ν) 3. the agent decides to learn information if ¯ θν t + (1 − θ)(1 − ν)t + [(1 − θ)ν + θ(1 − ν)]t0 − ψ ≥ t0 ¯ ≥ νt + (1 − ν)t. 4. not learning and always choosing the risky project). (4)) says that he prefers to learn the information (and follow the optimal choices induced by (1). note that (3) implies (1) and (4) implies (2). (3) (4) (2) (1) (3) (resp. and learning is optimal if this expression is positive. 2.From Bayes rule ¯σ Pr(S|¯ ) = ¯ θν Pr(¯ |S) Pr(S) σ ¯ = Pr(¯ ) σ θν + (1 − θ)(1 − ν) ¯ ¯ θν S + (1 − θ)(1 − ν)S (2θ − 1)ν S E(S|¯ ) = σ = >0 θν + (1 − θ)(1 − ν) θν + (1 − θ)(1 − ν) ¯ ¯ (1 − θ)ν S + θ(1 − ν)S (1 − 2θ)ν S = < 0.76 SOLUTIONS Inducing Information Learning 1. E(S|σ) = (1 − θ)ν + θ(1 − ν) (1 − θ)ν + θ(1 − ν) So. His ¯ expected utility if he decides to learn information is ¯ (2θ − 1)ν S − ψ. θν + (1 − θ)(1 − ν) θν + (1 − θ)(1 − ν) He chooses the safe project if he learns σ when ¯ (1 − θ)ν t θ(1 − ν)t + ≤ t0 . (2)) rather than not learning and always choosing the safe project (resp. the principal chooses the risky project if σ = σ and the safe project if σ = σ. Since the principal wants to minimize payments he chooses t = 0 t0 = ψ (2θ − 1)(1 − ν) ψ ¯ t = .

77 The principal’s expected utility is then ¯ ¯ (2θ − 1)ν S − θν t − [(1 − θ)ν + θ(1 − ν)]t0 θ + (1 − θ)ν + θ(1 − ν) ¯ = (2θ − 1)ν S − ψ · .It is worth inducing information revelation only if (5) is positive. This happens less often than if the principal was using the information technology himself since (5) can be rewritten ψ ¯ (2θ − 1)ν S − ψ − . (2θ − 1)(1 − ν) Otherwise. Inspired from Gromb and Martimort (2002). he should not use the agent. (2θ − 1)(1 − ν) (5) 5. .

78

SOLUTIONS

Optimal Contract and Limited Liability

**1- The optimal contract solves the following problem
**

q ¯

max

e 0

qf (q|e)dq − ψ(e)

Assuming the f (·) satisﬁes CDFC, we have a strictly concave objective function and the optimal ﬁrst-best eﬀort solves

q ¯ 0

qfe (q|e∗ )dq = ψ (e∗ ).

**2- The incentive constraint is
**

q ¯

t(q)fe (q|e)dq = ψ (e),

0

(1)

provided the agent’s objective function is strictly concave. It is when t (q) > 0, and f (·) satisﬁes CDFC. The participation constraint is

q ¯ 0

t(q)f (q|e) − ψ(e) ≥ 0.

(2)

**3- The principal’s problem becomes:
**

q ¯ 0≤t(q)≤q

max

(q − t(q))f (q|e)dq

0

subject to (1) and (2). Writing the Lagrangian, we get: L(q, t, e) = (q − t)f (q|e) + λ[tfe (q|e) − ψ (e)] + μ[tf (q|e) = ψ(e)], for t ∈ [0, q] where λ and μ are respectively the multipliers of (1) and (2) (μ ≥ 0 because (2) is an inequality. The objective is linear in t and the solution has a bang-bang feature if if if (μ − 1)f (q|e) + λfe (q|e) > 0 (μ − 1)f (q|e) + λfe (q|e) < 0 (μ − 1)f (q|e) + λfe (q|e) = 0 then t = q then t = 0 then t ∈ [0, q].

fe (q|e) f (q|e)

Note that MLRP ensures that there exists a unique q ∗ such that q ≥ q∗. Hence t = q iﬀ q ≥ q ∗ , t = 0 otherwise.

>

1−μ λ

for

79

The Value of Information under Moral Hazard

**1- The agent solves ˜ ¯ max E (θ + e)t − ψ(e)
**

e ˜ θ

**and we get ¯ ψ (e) = t. The principal solves ¯ max eS + (1 − e)S − ψ (e)e
**

e

which yields ΔS = ψ (eSB ) + eSB ψ (eSB ). 2- Now the agent adjusts his eﬀort e to have always a probability of success of R, i.e., e+θ =R He must be paid ˜ E (ψ (e)) = E (ψ (R − θ))

˜ θ ˜ θ

or

e = R − θ.

**to guarantee an eﬀort R. The principal solves ˜ ¯ RS + (1 − R)S − E (E ψ (R − θ))
**

˜ θ ˜ θ

**and the ﬁrst-order condition is ˜ ˜ ΔS = E (ψ (R − θ) + Rψ (R − θ)).
**

˜ θ

**˜ From ψ > 0 and Jensen’s inequality, we have E (ψ (R − θ)) ≥ ψ (R) and E (ψ (R −
**

˜ θ ˜ θ

˜ θ)) ≥ ψ (R) hence RSB < eSB .

80

SOLUTIONS

Raising Liability Rule

1- The optimal level of eﬀort is determined by minimizing h(1 − e) + ψ(e), i.e. by ψ (e∗ ) = h. Social welfare is then V − (1 + r)I − (1 − e∗ )h − ψ(e∗ ) > 0. ¯ 2- The proper incentive for the agent is obtained by choosing t and t such that ¯ ψ (e∗ ) = t − t. The agent’s participation constraint can be made binding by choosing t high enough ¯ V − (1 + r)I − e∗ t − (1 − e∗ )t − ψ(e∗ ) = 0. But then the payment to the bank ¯ e∗ t + (1 − e∗ )t = V − (1 + r)I − ψ(e∗ ) > (1 − e∗ )h is from (1) enough to pay h to the third party, when damage happens. 3- If the limited liability constraint of the borrower is binding, we have ¯ t = w t = w − ψ (e∗ ), and the expected revenue of the bank is w − (1 − e∗ )ψ (e∗ ) which must be larger than (1 + r)I + (1 − e∗ )c. Clearly, as w decreases this may become impossible. 4- This contract solves

¯ {e,t,t}

(1)

¯ max V − et − (1 − e)t − ψ(e) subject to ¯ t − t = ψ (e) ¯ t ≤ w

¯ et + (1 − e)t = (1 + r)I + (1 − e)c,

81 where the latter constraint is the bank’s zero proﬁt condition. dc eψ + 2ψ .t} ¯ max et + (1 − e)t − (1 − e)c ¯ t − t = ψ (e) ¯ t=w which reduces to max w − eψ (e) − (1 − e)c e or eψ (e) + ψ (e) = c with de 1 = > 0.t. Therefore e is determined by the zero proﬁt constraint (1 − e)c + eψ (e) = w − (1 + r)I. 5de 1−e =− <0 dc ψ + eψ − c for c small. This yields max V − w + (1 − e)ψ (e) − ψ(e) e subject to w − eψ (e) = (1 + r)I + (1 − e)c.The bank’s program is then ¯ {e. 6.

he ﬁnds it more interesting to get more insurance by having a constant payoﬀ across states. k is chosen to extract all the agent’s surplus ¯ e∗ q + (1 − e∗ )q − ψ(e∗ ) = k. 2. . The participation constraint of the agent is satisﬁed from the convexity of ψ(e) since ψ convex and ψ(0) ≥ 0 implies eψ (e) − ψ(e) ≥ 0. In the limit of an inﬁnite risk aversion. The principal solves max e e 1 − exp(−ρ(¯ − ψ (e))) q ρ + (1 − e) 1 − exp(−ρq) ρ .1.2. t=0 ¯ t = ψ (e). the agent’s rent is no longer viewed as costly and the ﬁrst-best eﬀort guarantees full insurance.82 SOLUTIONS Risk-Averse Principal and Moral Hazard 1.If the agent is protected by limited liability we get instead the standard results. ψ (eSB ) + eSB ψ (eSB ) = Δq as in Section 5. As the principal is more risk averse. eSB → e∗ .If the agent is risk neutral he will insure completely the principal so that: ¯ ¯ t = q − k and t = q − k which implies ¯ t − t = Δq and ψ (e∗ ) = Δq. This yields the following ﬁrst-order condition Δq = ψ (eSB ) + 1 ln(ρ + eSB ψ (eSB )). ρ If ρ → 0. If ρ → ∞. Finally.

dπ0 (1 − π0 )p∗ . Hence. dπ0 dδ ∗ < 0. Then. .e. (4) (3) Suppose (4) is satisﬁed. the ﬁrst order conditions hold: u(w − p∗ ) − uM (w) = (m − p∗ )u (w − p∗ ) δ∗ = (1) determines p∗ and (2) determines δ ∗ . δ ∗ (π1 ). π0 (m − p∗ ) (1) (2) 2. dw dδ ∗ > 0. it is immediate to see that dp∗ < 0. Health Care and Moral Hazard 1. if ψ ≤ Δπ(1 − δ ∗ (π1 ))(u(w − p∗ (π1 )) − uM (w)) = ψ ∗ .The problem of the utilitarian social welfare maximizer is max(1 − π0 + δπ0 )u(w − p) + (1 − δ)π0 uM (w) (p.83 Poverty. we obtain a solution like in 1 with π1 instead of π0 . dm dp∗ > 0. i. dw dp∗ = 0. Then g1 (·) cuts only once g2 (·) from above. It is indeed the solution if (4) holds for the optimal solution p∗ (π1 ). Let g1 (p) = u(w − p) − uM (w) and g2 (p) = (m − p)u (w − p). Then.δ) subject to δπ1 m = (1 − π1 + δπ1 )p (1 − π1 + δπ1 )u(w − p) + (1 − δ)π1 uM (w) − ψ ≥ (1 − π0 + δπ0 )u(w − p) + (1 − δ)π0 uM (w). dm and from (2) dδ ∗ < 0.δ) subject to δπ0 m = (1 − π0 + δπ0 )p.The problem becomes: max(1 − π1 + δπ1 )u(w − p) + (1 − δ)π1 uM (q) − ψ (p..

u22 = u(w − t22 ) and ϕ(·) ≡ u−1 (·). μ1 ) the multiplier of (5) (resp.u22 max 2 (1 − π1 )2 u11 + π1 (1 − π1 )(u12 + u21 ) + π1 u22 − ψ subject to ψ . the fact that poverty prevents treating every one is enough to create the incentives for health care. Note that (6) can be rewritten (1 − π1 )u11 + Δπ (2π1 − 1) ψ (u12 + u21 ) − π1 u22 ≥ + (u11 − u12 + u22 − u21 ). u21 = u(w − t21 ). u11 > u12 and u12 > u22 . Substituting (3) in (4) the optimal second best premium is such that Δπ 1 − pSB (π1 )(1 − π1 ) π1 (m − pSB (π1 )) u(w − pSB (π1 )) − uM (w) = ψ. Maximizing expected social welfare we have: u11 . For ψ higher than ψ ∗ . (1 − π1 )u11 + (u12 + u21 ) − π1 u22 ≥ 2π1 − 1 2 (5) (6) (7) Suppose that the constraint (6) is slack. μ1 μ1 π1 ϕ (u11 ) = from which u12 = u22 . For ψ even higher. pSB (π1 ) (and therefore δ(π1 )) decreases with ψ. the ﬁrst order conditions are 1 λ1 + μ1 μ(1 − π1 ) 1 λ1 (2π1 − 1) ϕ (u12 ) = ϕ (u21 ) = + μ1 2π1 (1 − π1 )μ1 1 λ1 ϕ (u22 ) = − . u12 = u(w − t12 ). health care is given up. 2Δπ ψ (2 − π1 − π0 )u11 + (π1 + π0 − 1)(u12 + u21 ) − (π1 + π0 )u22 ≥ Δπ 2 2 (1 − π1 ) ϕ(u11 ) + π1 (1 − π1 )(ϕ(u12 ) + ϕ(u21 )) + π1 ϕ(u22 ) ≤ w − π1 m. the incentive constraint becomes binding. 3. u11 − u12 + u22 − u21 = 0 and the global incentive constraint is 2 satisﬁed.u21 . u11 > u22 .Let u11 = u(w − t11 ).84 SOLUTIONS Then. . Then. 2 2Δπ 2 (8) Hence for ϕ(u) = 1 u2 . (7)).u12 . and let λ1 (resp.

85 In an individual contract we must solve: max(1 − π1 )u1 + π1 u2 ψ Δπ (1 − π1 )ψ(u1 ) + π1 ψ(u2 ) ≤ w − π1 m u 1 − u2 ≥ hence 1 λ + μ μ(1 − π1 ) 1 λ ψ (u2 ) = . − μ μπ1 ψ (u1 ) = which is like having the constraints u11 = u12 and u21 = u22 in the previous problems. Laﬀont. J. This can only happen if λ1 = 0 which is impossible when there is moral hazard. .J. (2003a). (λ) (μ).

p−p ¯ (4) 3. then there is no lending. ¯ ¯ ¯ . So. ¯ p ¯ From (4) px + (1 − p)y ≥ ¯ ¯ hence p(z − (¯x + (1 − p)y)) − r ≤ pz − r − p ¯ p ¯ ¯ ¯ ψ . Clearly (1) implies (2) and is binding so that ψ x= p−p ¯ and the bank’s expected proﬁt is pz − ¯ pψ ¯ − r.86 SOLUTIONS Group Lending with Moral Hazard 1. ¯p ¯ p ¯ The bank’s expected proﬁt per entrepreneur is p(z − (¯x + (1 − p)y)) − r. The bank solves the problem: max p(z − x) − r ¯ x≥0 px − ψ ≥ px ¯ px − ψ ≥ 0. Suppose that the local incentive constraint is not binding. because the bank maximizes proﬁt. p−p ¯ (3) If (3) is negative. p−p ¯ ψ . We may indeed have pz − ¯ pψ ¯ − r < 0 < pz − r.Eﬀort provision is a Nash Equilibrium if p(¯x + (1 − p)y) − ψ ≥ p(¯x + (1 − p)y). ¯ (1) (2) where (1) is the incentive constraint and (2) the participation constraint. It can be rewritten: p2 x + p(1 − p)y − ψ ≥ p2 x + p(1 − p)y.Since r > pz. it may not lend. ¯ p−p ¯ 2. when it is socially valuable to lend. the only potentially valuable contract is a contract which induces eﬀort.Constraint (3) in the text is implied by (1).

The bank’s expected proﬁt per entrepreneur is pz − r − ¯ p2 ψ ¯ p ¯ pψ ¯ = pz − r − ¯ · 2 − p2 p ¯ p+p p−p ¯ ¯ greater than the expected projet in the optimal individual contract pz − r − ¯ pψ ¯ .J. J. y = 0. When considering a deviation to zero eﬀort. Incentives provision is easier with group lending.. p p ¯ ψ The solution of the maximization’s bank under constraint (1) is x = p2 −p2 . ¯ the entrepreneurs are rewarded only if they both succeed. Under group lending. Rey (2003b). and P.: 2(¯2 − p¯) · p p p2 ¯ ψ ≥ ψ − p2 p ¯ ≥ 1 or p ≥ p ¯ 2 p+p ¯ which holds. an agent takes into account the negative externality he exerts on the other since such a deviation makes it less likely that the other agent receive a reward. It remains to check that (2) is satisﬁed by this solution. Laﬀont. . p−p ¯ Group lending dominates. agents coordinate their choices of eﬀort.87 The bank’s expected proﬁt is 2¯(z − (¯x + (1 − p)y)) − 2r. i.e.e. i.

2 ¯ θ q= . 1−ν . under ex ante contracting with a risk-neutral agent. U ) which implement this allocation. ¯ 3. the optimization of the principal yields immediately: ν ¯ u (q) = u (θ − q) + u (θ − q) − u (θ − q) . t) or rents (U .e.t).The principal solves max u(q) + t subject to u(θ − q) − t ≥ 0. i. ¯ 2 ¯ ¯ and that there are many pairs of transfers (t.The principal solves {(¯. hence the solution q = 2. the principal achieves the ﬁrst best θ q= .88 SOLUTIONS Incentives and Discovery 1.Suppose on the contrary that the “usual” constraints. When those constraints are binding.. the θ-incentive constraint and θ-participation constraint are binding. we know that. From Chapter 2. Then: U = u(θ − q) − t = 0 ¯ ¯ ¯ ¯ ¯ U = u(θ − q ) − t = u(θ − q) − t ¯ = u(θ − q) − t + u(θ − q) − u(θ − q) = u(Δθ + θ − q) − u(θ − q).t)} q¯ θ 2 and t = u θ 2 . q subject to ¯ ¯ ¯ ¯ ¯ U = u(θ − q ) − t ≥ u(θ − q) − t ¯ U = u(θ − q) − t ≥ u(θ − q ) − t ¯ ¯ ¯ ¯ ν(u(θ − q ) − t) + (1 − ν)(u(θ − q) − t) ≥ 0. max ¯ ν(u(¯) + t) + (1 − ν)(u(q) + t).(q.

¯ θ + (1 − ν)u 2 θ 2 − νu(Δθ). 4. u (θ − q) > u (θ − q).Note that for Δθ = θ or θ = 2θ dW (ν) = 2 u(θ) − u dν = u(θ) − 2u Note that d ¯ dθ dW dν d = ¯ 2 u dθ ¯ θ −u 2 θ 2 − u(Δθ) =u ¯ θ − u (Δθ) < 0. ¯ θ q= . Indeed. Therefore q < θ and ¯ U = u(Δθ + θ − q) − u(θ − q) < u(Δθ) − u(0) = u(Δθ). let us check that the incentive constraints are then slack u ¯ θ θ ¯ − t = u(Δθ) > u Δθ + 2 2 −u θ 2 . from the concavity of u(·): u since u θ 2 − t = 0 > u(−Δθ) − u ¯ θ 2 ¯ θ . .If only the participation constraints are binding t = u(θ − q). 2 θ 2 θ 2 − u(θ) < 0. hence u (q) > u (θ − q) hence q < θ − q or q < 2 . ¯ 2 These are the relevant constraints when Δθ > θ. a contradiction with the assumption that the optimal contract entails the postulated binding constraints. ¯ so that the θ ex post participation constraint (2) is not satisﬁed. 2 > u(0) > u(−Δθ). The optimal solution entails q= θ 2 and ¯ ¯ ¯ t = u(θ − q ) − u(Δθ).89 θ ¯ Since u < 0. The principal’s expected welfare is W (ν) = 2 νu ¯ 5.

(2) and (3) become ψ ¯ ¯ ¯ u(θ − q ) − t ≥ max u(Δθ).t) q ¯ ¯ ¯ q q max ν0 (u(¯) − t) + (1 − ν0 )(u(¯) − t). J. Since W is decreasing in ν. the principal does not wish to encourage eﬀort but in the contrary to discourage eﬀort. ν0 (u(θ − q ) − t) + (1 − ν0 )(u(θ − q) − t) ≥ ν1 (u(θ − q ) − t) + (1 − ν1 )(u(θ − q) − t) −(3) With (1) is binding. subject to u(θ − q) − t ≥ 0 (1) ¯ ¯ ¯ u(θ − q ) − t ≥ u(Δθ) (2) ¯ ¯ ¯ ¯ ¯ ¯ ψ. Δν .J. q = 2 .t. Δν or. . dW (ν) dν So ¯ < 0 for all θ such that Δθ > θ. ψ ¯ ¯ ¯ t = u(θ − q ) + Δν and t = u(θ − q). since u(Δθ) < ψ . (2003c).90 SOLUTIONS iﬀ ¯ θ 2 ¯ < Δθ or θ > 2θ or Δθ > θ. He solves the program: (q. eﬀort is discouraged with the eﬃcient sharing of resources q = 2 . ¯ θ Therefore. ¯ θ Laﬀont.¯.

2. β − C2 ) + C1 + C2 ¯ +ν(ψ(β − C 1 . β − C2 ). β − C2 ) ≥ t − ψ(β − C 1 . The incentive constraints are ¯ ¯ ¯ ¯ ¯ ¯ ¯ ¯ U = t − ψ(β − C1 . or ¯ U ≥ U − Φ(C 1 .MIXED MODELS Political Economy of Regulation 1{t. e2 ) = t − ψ(β − C1 . β − C2 ) − ψ(β − C1 . β − C 2 ) ≥ t − ψ(β − C1 .C2 . β − C 2 ) ¯ ¯ ¯ U = t − ψ(β − C 1 . C2 ) = ψ(β − C1 .e1 . β − C2 ). ¯ ¯ with Φ(C1 .C1 . C2 ).Let U = t − ψ(e1 .91 III.e2 } max W = S1 + S2 − (1 + λ)(t + C1 + C2 ) + U subject to t− 1 2 (e1 + e2 ) + γe1 e2 2 2 ≥0 Ci = β − ei hence e1 = e2 = i = 1. 1 . (3) (4) (1) (2) . β − C2 ). C 2 ) ¯ ¯ ¯ U ≥ U + Φ(C1 . β − C 2 ) + C 1 + C 2 ) − λ(νU + (1 − ν)U ). The participation constraints are ¯ U ≥ 0 U ≥ 0. Expected welfare can be written ¯ ¯ ¯ ¯ ¯ ¯ EW = S1 + S2 − (1 + λ) (1 − ν) ψ(β − C1 . 1+γ 2.

Laﬀont and Pouyet (2003). This democratic ﬂuctuation of policies is detrimental and opens the possibility that decentralization of the regulation of each project in each region could dominate this centralized regulation. because they undervalue (overvalue) rents with respect to the maximization of social welfare. 1+γ For a majority of shareholders we ﬁnd e1 = e2 = e1 ¯ 1 1+γ 1 = e2 = ¯ − 1+γ (1 + λ)α − 1 (1 + λ)α ν Δβ. 1−ν So a majority of non-stakeholders (stakeholders) distorts downward too much (too little) eﬀort.92 SOLUTIONS Assuming that (2) and (3) are binding and optimizing we ﬁnd e1 = e2 = e1 ¯ 1 1+γ 1 λ ν = e2 = ¯ − Δβ. .For a majority of non-shareholders we ﬁnd e1 = e2 = e1 ¯ 1 1+γ 1 = e2 = ¯ − Δβ. 1+γ 1+λ1−ν 3.

Chapter 4. .93 Regulation of Quality For the solution see Laﬀont and Tirole (1993).

The solution is S (q ∗ ) + λ(p (q ∗ )q ∗ + p(q ∗ )) = (1 + λ)(β − e∗ ) ψ (e∗ ) = q ∗ U = 0.From the Revelation Principle we can restrict the analysis to the pair {(t. ¯¯ 2. There are many transfers (or rents) which implement the eﬃcient allocation.e. β) + H F ¯ UE = − .U ) max S(q) + λp(q)q − (1 + λ)((β − e)q + F + ψ(e)) − λU subject to U = t − ψ(e) ≥ 0. c)}.The ﬁrm’s new participation constraint is ¯ ¯ νU + (1 − ν)π(c)U + (1 − ν)(1 − π(c))U E ≥ 0. From Chapter 2 we know that eﬃciency is achieved for adverse selection problems and ex ante participation constraints when the agent is risk neutral.94 SOLUTIONS Enforcement and Regulation 1. and the ﬁrm’s rent level ˆ q ¯ ¯ δ W (¯∗ . c).The outcome of renegotiation entails eﬃcient levels of production q ∗ and eﬀort e∗ since ¯ ¯ ¯ renegotiation takes place under complete information when β = β. It is incentive compatible if ¯ U = t − ψ(β − c) ≥ t − ψ(β − c) ¯ ¯ ¯ ¯ ¯ ¯ U = t − ψ(β − c) ≥ t − ψ(β − c). 2λ 2 4.The regulator solves (q. The ﬁrm’s ex ante participation constraint is ¯ νU + (1 − ν)U ≥ 0. . e∗ . 3. (t.

¯.e.95 The regulator solves now: (q. β) − λU ] + (1 − ν)π(c)[W (¯. e. e∗ . We obtain immediately qE = q∗ qE = q∗ ¯ ¯ (1 − ν)π (cE ) = eE = e∗ eE = e∗ ¯ ¯ 1+λ .c) qe ˆ ˆ q ¯ ¯ ¯ max ν[W (q.¯. β) − λU ] ¯ +(1 − ν)(1 − π(c))[δW (¯∗ . e. ˆ q ¯ ¯ (1 − δ)W (¯∗ . β) − λU E ] − (1 + λ)c. β) Laﬀont. q ¯ ¯ under the participation and incentive constraints. .J. J. e∗ . (2002).

As usual (1) and (4) are the relevant constraints and they can be rewritten π ≥ 0 ¯ ¯ ¯ ¯ ¯ π ≥ π + ψ(β − C) − ψ(β − C) ¯ H(C) (5) (6) The regulator’s optimization program reduces to ¯ π {C.The participation constraints are ¯ ¯ ¯ u(t − ψ(β − C)) ≥ 0 u(t − ψ(β − C)) ≥ 0. and the certainty equivalent of the manager’s welfare.C. (1) (2) (3) (4) 2.C} ¯ ¯ ¯ ¯ max S − (1 + λ) ν(H(C) + ψ(β − C) + C) + (1 − ν)(ψ(β − C) + C) .¯ } ¯ ¯ ¯ max S − (1 + λ) ν(π + ψ(β − C) + C) + (1 − ν)(¯ + ψ(β − C) + C π π +u−1 (νu(π) + (1 − ν)u(¯ )) subject to (5)-(6) or ¯ {C.96 SOLUTIONS Regulation of a Risk Averse Firm 1.Social welfare adds the utility of consumers when they pay for the cost (t + C) from distortionary taxes with a social cost of public funds 1 + λ. Since u > 0 and u(0) = 0 they reduce to ¯ ¯ π = t − ψ(β − C) ≥ 0 ¯ ¯ π = t − ψ(β − C) ≥ 0 ¯ ¯ ¯ ¯ t − ψ(β − C) ≥ t − ψ(β − C) ¯ ¯ t − ψ(β − C) ≥ t − ψ(β − C).π. The incentive constraints are ¯ ¯ ¯ ¯ u(t − ψ(β − C)) ≥ u(t − ψ(β − C)) ¯ ¯ u(t − ψ(β − C)) ≥ u(t − ψ(β − C)).

hence ψ (e) = 1 ψ (¯) = 1 + e ¯ ¯ ν νu (H(C))H (C) ¯ H (C) − ¯ 1−ν (1 − ν)(1 + λ)u (u−1 (νu(H(C))) ˙ 3. the regulator perceives more negatively the randomness of the ﬁrm’s rents and decreases eﬀort to decrease the information rent. 1+λ1−ν decreases with ρ (since H < 0). ν e−ρH 1− H. ¯ Thus. ¯ 1−ν (1 + λ)(1 − ν(1 − e−ρH(C) )) As ρ increases. ψ (e) = 1 e ψ (¯) = 1 + ¯ ν H (C) ¯ H (C) − 1−ν (1 − ν)(1 + λ) ¯ ¯ ¯ ¯ ¯ ¯ u(H(C)) > νu(H(C)) implies H(C) > u−1 (νu(H(C))) or u (H(C)) < u (u−1 (νu(H(C)))). ψ (·) > 0 implies e is smaller when the ﬁrm is risk-neutral. Then u (c) = 1. e decreases if ¯ e−ρH ¯ (1−ν(1−e−ρH(C) )) But this expression is equal to 1 ¯ (1 − ν)eρH(C) + ν which is a decreasing function of ρ. u(x) = x.When the ﬁrm is risk neutral. . So eﬀort decreases as risk aversion increases. Indeed. 41 (1 − e−ρx ) ρ u (H) = e−ρH u(x) = ψ (¯) = 1 + e If ρ = 0 ψ (¯) = 1 + e λ ν ¯ H (C) 1+λ1−ν λ ν = 1− e Φ (¯).97 ¯ +u−1 (νu(H(C))).

4 If β1 = 3.Optimal regulation for ﬁrm 1: max S − (1 + λ)(t1 + C1 ) + t1 − subject to (P C) e2 t1 − 1 ≥ 0. the problem becomes: e2 max S − (1 + λ) 1 + β1 − e1 e1 4 FOC with respect to e1 : (1 + λ) − (1 + λ) 21 = 0 e∗ = 2.Optimal contract for ﬁrm 2. . Substituting P C into the objective function. 4 e2 1 4 (t1 .e2 } 2 e 4 e2 1 S − (1 + λ)(t2 + 3k − e2 ) + t2 − 2 + 2 4 max (3) (1) e∗ (2) .C1 ) t1 is costly. 4 Ex ante welfare (expected) is: 1 1 W1 = [S − λ − 1] + (S − λ − (1 + λ) − 1) 2 2 or 3 W1 = S − (1 + λ). then C1 = 3 − e∗ = 1 1 e∗2 t1 = 1 = 1. 2 2. P C will bind. therefore. 1 If β1 = 2. Regulator solves: e2 ¯ 1 ¯ ¯ ¯ S − (1 + λ)(t2 + 3k − e2 ) + t2 − 2 {¯2 . then C1 = 2 − e∗ = 0 1 e∗2 t1 = 1 = 1.98 SOLUTIONS Technological versus Informational Advantage 1.

99 subject to e2 2 4 e2 ¯ ¯ t2 − 2 4 e2 ¯ ¯ t2 − 2 4 e2 t2 − 2 4 t2 − (P C) and (IC) bind so that e2 ¯ ¯ t2 = 2 4 e2 e2 (¯2 − k)2 ¯ e t2 = 2 + 2 − . 8(1 + λ) (4) ≥ 0 ≥ 0 ≥ t2 − (P C) (P C) (IC) (IC). e2 . 4 4 4 Substituting into the objective function and maximizing with respect to e2 . From (7) and (3): (W2 − W1 ) ≥ 0 ⇔ ⇒ ⇒ λ(1 + 2λ) 2 (5 + 6λ) 5 k − k + (1 + λ) ≥ 0. we ¯ λ obtain e2 = 2. (5) and (6) gives us the expected social welfare: W2 = 1 λ(1 + 2λ) 2 k − (5 + 6λ)k + [S + (1 + λ)]. 1+λ 4(1 + λ)2 6λ + 2 · k2. 2 4(1 + λ) (6) (7) 3.Condition on λ and k for selection of ﬁrm 2. 8(1 + λ) 2 2 5 (1 + λ) > 0 2 λ(1 + 2λ) 5 + 6λ 5 = − + (1 + λ) 8(1 + λ) 2 2 λ(1 + 2λ) λ = − < 0 (for λ > 0). Substituting (4). (e2 + k)2 4 (¯2 − k)2 e ¯ ≥ t2 − 4 t2 = 1 + k − (5) (3 + 4λ)k ¯ −2 C2 = 3k − e2 = ¯ (1 + λ) C 2 = 2k − e2 = 2k − 2. e2 = 2 − 1+λ k and ¯ ¯ t2 = 1 − λ2 λ k+ · k2. 8(1 + λ) 2 (8) k=0 k=1 W2 − W1 = W2 − W1 .

W1 is either W1 = S − (1 + λ)(t1 + C 1 ) if β1 = 2.Choosing ﬁrm in the interim stage. Since (W2 − W1 ) is decreasing over the entire range k in [0. If the choice is made in the interim stage. 5+6λ 2 k< then choose ﬁrm 2.e. below which ﬁrm 2 is preferred. − 26λ2 +55λ+25 4 2 λ(1+2λ) 8(1+λ) (9) 4. 1] and (W2 − W1 ) > 0 for k = 0 and (W2 − W1 ) < 0 for k = 1 the smaller of the two roots of the quadratic equation (8) gives the value of k. C1 = 1 ⇒ W1 = S − 2(1 + λ). i. 1). 1]. t1 = 1. Case 1: β1 = 2 W 2 − W1 = λ(1 + 2λ) 2 (5 + 6λ) k − k + 2(1 + λ) 8(1 + λ) 2 ⇒ (W2 − W1 ) > 0 ⇒ (W2 − W1 ) < 0 5 + 6λ 2 <0 for any k in (0. (10) k=0 k=1 d λ(1 + 2λ) (W2 − W1 ) = k− dk 4(1 + λ) The smaller root of the quadratic equation is 5+6λ 2 R1 = − 28λ2 +56λ+25 4 2 λ(1+2λ) 8(1+λ) . or ¯ ¯ W1 = S − (1 + λ)(t1 + C1 ) if β1 = 3. t1 = 1.100 SOLUTIONS Also. λ(1 + 2λ) d 5 + 6λ (W2 − W1 ) = k− <0 dk 4(1 + λ) 2 for any k in [0. C 1 = 0 ⇒ W1 = S − (1 + λ) ¯ ¯ β1 = 3. (11) . From above: If β1 = 2..

Note that W1 does not depend on k. Can be done in a similar manner as Case 1.101 If k < R1 . 1). So the optimal k will now be given by: max W2 − k 1 λ(1 + 2λ) 2 (1 + λ)(3 − k)2 k − (5 + 6λ)k + [S + (1 + λ)] − 2 4(1 + λ) 2 (1 + λ)(3 − k)2 2 gives k∗ = 2(1 + λ) . 7λ + 2λ2 + 4 (12) The optimal strategy depends upon comparing W2 with W1 : W2 −W1 = or W2 − W1 = 1 λ(1 + 2λ) 2 (1 + λ)(3 − k) 3 k − (5 + 6λ)k +[S +(1+λ)]− − S − (1 + λ) . so any k in (0. 1) is optimal. Case 2: β1 = 3. 5.For any k. W2 is now given by W2 = from (7). the optimal strategy is to always choose ﬁrm 1. 2 4(1 + λ) 2 2 −2λ2 − 7λ − 4 2 1 k + k − 2(1 + λ) < 0 8(1 + λ) 2 for any k in (0. Therefore. then choose ﬁrm 2 at the interim stage when β1 = 2 for ﬁrm 1. .

qc ) 1 2 2 max −e−ρ[R(q0 +αqc )−p0 q0 −μqc − 2 ρqc σ ] or R (q0 + αqc ) = p0 αR (q0 + αqc ) = μ + ρqc σ 2 αp0 − μ qc (p0 ) = . ρσ 2 Since R(q0 + αqc ) = a(q0 + αqc ) − 1 b(q0 + αq2 )2 2 a − b(q0 + αqc ) = p0 a − p0 α(αp0 − μ) − b ρσ 2 2 aρσ + αμb p0 = − (ρσ 2 + α2 ).qc ) c max E −e−ρ(R(q0 +αqc )−p0 q0 −˜qc is equivalent to (q0 . 2 ρσ 2 + α2 b (3) ∂pM 0 ∂μ ∂pM 0 ∂c ∂pM 0 ∂α ∂pM 0 ∂σ 2 1 αb >0 2 ρσ 2 + α2 b 1 = >0 2 1 ρσ 2 b(μ − 2aα) − 2α2 μb2 = 2 (ρσ 2 + α2 b)2 1 (ρσ 2 + α2 b)aρ − (aρσ 2 + αμb)ρ = 2 (ρσ 2 + α2 b)2 = . (p0 − c) dq0 + q0 (p0 ) = 0 dp0 pM 0 1 aρσ 2 + αμb = +c . i. bρσ 2 bρσ 2 (1) q0 (p0 ) = (2) The monopoly maximizes (p0 − c)q0 (p0 ).e.102 SOLUTIONS Piracy and Optimal Pricing 1(q0 .

(1) and (3) respectively. (4) From (2) and (3): M ∂q0 ∂μ ∂pM 0 ∂μ = α ρσ 2 1 αb = 2 + α2 b 2 ρσ . Substituting in (4): ˜ ∂W [3(ρσ 2 + α2 b)c + aρσ 2 ]α 4ρσ 2 + 3α2 b μ − = . From the 0 envelop theorem M ˜ ∂W ∂q0 M M ∂p0 = (p0 − c) + −q0 ∂μ ∂μ ∂μ M − qc . qc and pM are given by equations (2). ∂μ 4(ρσ 2 + α2 b) ρσ 2 4(ρσ 2 )(ρσ 2 + α2 b) (5) .W = (p0 − c)q0 + R(q0 + αqc ) − p0 q0 − μqc − 1 ρqc σ 2 . = qc R (q0 + αqc ) > 0 = −qc < 0 1 2 = − ρqc 2 = −q0 < 0. 2 M M where q0 . 2 The optimal levels of q0 and qc are obtained by maximizing W with respect to q0 and qc . 2 2. ∂pM αbσ 2 (aα − μ) 0 = ∂ρ (ρσ 2 + α2 b)2 <0 <0 if if aα > μ aα < μ. By the Envelope Theorem ∂W ∂α ∂W ∂μ ∂W ∂σ 2 ∂W ∂c Welfare under monopoly is: 1 M M M M M ˜ W = (pM − c)q0 + a(q0 + αqc ) − b(q0 + αqc )2 0 2 1 2 M M M M 2 −p0 q0 − μqc − ρσ − (qc ) .103 ∂pM ραb(aα − μ) 0 = 2 ∂σ (ρσ 2 + α2 b)2 >0 <0 if if aα > μ aα < μ.

q0 and qc in the objective function. 2 2 (7) Substituting F . ˜ ˜ ∂W ∂W = .Two part tariﬀ (p0 . ∂μ ∂f The optimal ﬁne is given by: 1 ˜ max W − δf 2 . the problem becomes a − p0 1 max −cq0 + a − b p0 b 2 a − p0 b 2 −μ αp0 − μ ρσ 2 ρσ 2 − 2 αp0 − μ ρσ 2 2 . ρσ 2 2 ρσ 2 qc − F ≥ 0 (P C).A subject to R(q0 + αqc ) − p0 q0 − μqc − Hence q0 = qc a − p0 α(αp0 − μ) − b ρσ 2 αp0 − μ = . f 2 hence: ˜ ∂W − δf = 0 ∂f 4ρσ 2 + 3α2 b 4ρσ 2 (ρσ 2 + α2 b) || or f + Ac0 − Bα − δf = 0 A where B= or 3(ρσ 2 + α2 b)c + aρσ 2 4ρσ 2 (ρσ 2 + α2 b) −Ac0 + Bα . F ) (6) max(p0 − c)q0 + F p0 .0 A−δ f = max 3. 2 The participation constraint will bind (because raising F is desirable for the monopolist). Therefore: 2 b ρσ 2 qc F = a(q0 + αqc ) − (q0 + αqc )2 − p0 q0 − μqc − .104 SOLUTIONS Given that μ = c0 + f .

q . Let us now show that the Spence-Mirrlees property holds: 1 2 V (t0 .O. ρ) ¯ ¯ ¯ V (t0 . ρ) ≥ V (t0 . q0 .Substituting p0 = c in the expression for q0 . qc and (7) gives us the lumpsum payment F. qc 2 Hence the F. ρ) ≥ 0 V (t0 . ρ) = aq0 − bq0 + − t0 . ∂ ∂V /∂q0 b(α2 (a − bq0 ) − αμ) = −σ 2 < 0. q0 . ρ) ≥ V (t0 .t0 )} q (10) max ¯ ν[t0 − cq 0 ] + (1 − ν)[t0 − c¯0 ] q subject to ¯ ¯ ¯ V (t0 . 2 2 bα2 + ρσ 2 The monopolist’s problem is: ¯ {(q 0 . q 0 . ρ) = max R(q0 + αqc ) − t0 − μqc − ρσ 2 qc . ρ) = a q0 + bα2 + ρσ 2 − μα(a − bq0 ) − μ2 bα2 + ρσ 2 b − 2 α2 (a − bq0 ) − αμ q0 + bα2 + ρσ 2 2 2 α(a − bq0 ) − μ bα2 + ρσ 2 (9) − t0 1 α(a − bq0 ) − μ − ρσ 2 2 bα2 + ρσ 2 ∂V = 1 ∂t0 ∂V = a − b(q0 + αqc ) = a − bq0 − b ∂q0 α2 (a − bq0 ) − αμ bα2 + ρσ 2 .C. q0 .: α(a − b(q0 + αqc )) − μ − ρσ 2 qc = 0 qc = or α2 (a − bq0 ) − αμ V (t0 . ρ) ≥ 0 (P C) (P C) (IC) (IC).(t0 . ¯ ¯ ¯ V (t0 .¯0 ). ρ) 0 . q0 .105 p0 = c. ∂ρ ∂V /∂t0 (bα2 + ρσ 2 )2 1 2 1 (α(a − bq0 ) − μ)2 V (t0 . q0 . q 0 . q0 . (8) 4.

. 2 + ρσ 2 )(bα2 + ρσ 2 ) 2 (bα ¯ (12) Substituting (11) and (12) in the objective function and maximizing w. i. C. Crampes.J. D will be a decreasing function of q0 and since ¯ E is positive we need q0 to be greater than that under complete information case for the ¯ above FOC to hold).r.e. (If the problem is concave. there is an upward distortion in the quantity sold to the low type. q 2 + ρσ 2 2 2 bα ¯ and 2 1 1 (α(a − bq 0 ) − μ) t0 = aq 0 − bq 2 + 2 0 2 bα2 + ρσ 2 (11) − 1 [α(a − b¯0 ) − μ]2 Δρσ 2 q . Using (10) and this fact we get: 1 2 1 (α(a − b¯0 ) − μ)2 q ¯ t0 = a¯0 − b¯0 + q . and J.t. q 0 and q0 ¯ we get: (−αb) [α(a − bq 0 ) − μ] − c = 0 q 0 : a − bq 0 + 2 bα + ρσ 2 (E) q0 : ¯ +ν (bα2 α(a − b¯0 ) − μ q (αb)Δρσ 2 2 )(bα2 + ρσ 2 ) + ρσ ¯ bα2 αb [α(a − b¯0 ) − μ] − c = 0 q + ρσ 2 ¯ (D) +(1 − ν) a − b¯0 − q q 0 is the same as under complete information case and q0 is greater than that under ¯ the complete information case. Laﬀont (2002) .106 SOLUTIONS (P C) and (IC) will bind.

which yields the second-best solution S (q SB ) = θ. .t)} q¯ subject to ¯ q t − θq ≥ t − θ¯ ¯ ¯ ¯q t − θ¯ ≥ t − θq t − θq ≥ 0 ¯ ¯q t − θ¯ ≥ 0. (1) is strictly satisﬁed.t). which can be improved by lowering the e and e in the same amount ε. Since t − θ¯ < 0 the agent accepts only the contract ¯ ¯ if θ = θ. His expected utility is then ¯ ¯q ν max(0. (1) The optimization problems of the principal are formalized as shown below in the solution of question 2.Consider a contract in the class C2 .(q. ¯ The principal’s utility level is V SB . ¯ ¯q If t − θq ≥ 0 and t − θ¯ ≥ 0.107 Gathering Information before Signing a Contract 1. t − θq) + (1 − ν) max(0. The principal must then solve the classical problem ¯ q max ν(S(q) − t) + (1 − ν)(S(¯) − t) {(¯.If the agent learns θ he accepts the contract only if t − θq is non-negative. ¯ S (¯SB ) = θ + q ν Δθ 1−ν (2) (3) (4) (5) q t = θq SB + Δθ¯SB . Accordingly the moral hazard constraint inducing no eﬀort in gathering information is ¯ ¯q ¯ ¯q ν(t − θq) + (1 − ν)(t − θ¯) ≥ ν max(0. The principal can mimic this contract by choosing t = q = 0 and the agent saves the information cost. t − θq) + (1 − ν) max(0. t − θ¯) − ψ. ¯ ¯q 2. t − θ¯) − ψ. It is easy to check the new contract still belong to C1 . So the principal can always mimic a contract in the class C2 with a contract in the class C1 . ¯ ¯q t = θ¯SB .

¯ q S (¯F B ) = θ with a zero expected rent ¯ ¯q ν(t − θq F B ) + (1 − ν)(t − θ¯F B ) = 0. t − θ¯) ≥ 0. t − θ¯) − ψ moral hazard constraint. (12) .108 SOLUTIONS This solution is the one obtained when the agent is informed costlessly. So. If (8) is binding and not (9). So it cannot be dominated by a solution in which the agent is informed at the cost ψ. t − θ¯ < 0. We know that the principal can reach the ﬁrst best S (q F B ) = θ. The moral hazard constraint becomes ¯ ¯q (1 − ν)(t − θ¯) ≥ −ψ.Let us come back to the maximization in the class C1 . The general optimization problem in the class C1 is {(q. the only other interesting ¯ ¯q case to consider is t − θq > 0. t − θ¯) − ψ ≥ 0 ¯ ¯q ν max(0. t − θq) + (1 − ν) max(0.(¯. with (9) replaced by (1 − ν)(t − ¯q θ¯) ≥ −ψ.. t−θq ≥ 0 if t − θ¯ ≥ 0.e. The maximimand in the class C2 is ν(S(q) − t). t − θq) + (1 − ν) max(0.t). This case is valid if (9) is not binding. For the maximization in the class C2 . (10) (11) ¯ 3. if ¯ ¯q (1 − ν)(t − θ¯F B ) ≥ −ψ. ¯ ¯q From the incentive constraint (2). we have a classical problem with an ex ante participation constraint. i. (8) and (9) are replaced by ¯ ¯q ν max(0.t)} q¯ max ¯ ν(S(q) − t) + (1 − ν)(S(¯) − t) q subject to ¯ t − θq ≥ t − θ¯ q ¯ ¯ ¯q t − θ¯ ≥ t − θq incentive constraint incentive constraint participation constraint (6) (7) (8) (9) ¯ ¯q ν(t − θq) + (1 − ν)(t − θ¯) ≥ 0 ¯ ¯q ¯ ¯q ν(t − θq) + (1 − ν)(t − θ¯) ≥ ν max(0. t − θq) + (1 − ν) max(0.

1−ν ψ 1−ν The optimal quantities are the second-best ones and the welfare of the principal is V SB + This solution is valid if (4) is satisﬁed ν Δθ¯ − q or ψ ≤ ν(1 − ν)Δθ¯SB . when (8) (9) are binding as well as (6) we obtain S (q) = θ and q= ¯ Summarizing we have: T ψ . q Then (12) becomes ψ ≥ (1 − ν)νΔθ¯F B . ν(1 − ν)Δθ qF B q SB 222 222 222 222 222 222 22 E ψ ν(1 − ν)Δθ¯SB q ν(1 − ν)Δθ¯F B q The principal suﬀers from the ability of the agent to become informed about its type before contracting. When ψ . 1−ν ψ 1−ν + (1 − ν) − ψ 1−ν >0 ψ . q Finally.109 ¯ ¯q The highest value of t − θ¯ is obtained when the incentive constraint (6) is binding ¯ t − θq F B = t − θ¯F B hence from (8) q ¯ ¯q t − θ¯F B = −νΔθ¯F B . If ψ = 0 it is as if contracting was at the interim stage. q If (9) is binding and not (8) ¯ ¯q t = θ¯ − and from the incentive constraint t = θq + Δθ¯ − q ψ .

Cr´mer and Khalil (1992). Sappington (1984). e .110 SOLUTIONS is large enough the principal can achieve the ﬁrst-best and as ψ increase the principal’s utility increases between V SB and V F B . Demski and Sappington (1986).

ψ (¯(ν)) = 1 − ¯ e U = Φ(¯) .U )} e ¯ max ¯ ¯ ¯ e ν S − (1 + λ)(β − e + ψ(e)) − λU + (1 − ν) S − (1 + λ)(β − e + ψ(¯)) − λU subject to ¯ U ≥ U + Φ(¯) e ¯ U ≥ U − Φ(e + Δβ) U ≥ 0 ¯ U ≥ 0. U = 0. e 2.111 Better Information Structures and Incentives 1. e 1 + λ 1 − νi ˆ (1) the solution of (1). The regulator’s program is {(e.Social welfare is W = S − (1 + λ)(t + β − e) + U = S − (1 + λ)(ψ(e) + β − e) − λU. Hence. When the regulator keeps both types of ﬁrms ˆ I I ¯ Eσi νi = Eσi E(1 {β} |σi ) = E1 {β} = ν . λ ν e Φ (¯(ν)) 1+λ1−ν Furthermore there is shutdown of the ineﬃcient ﬁrm (with U = 0) if ν ≥ ν ∗ deﬁned as the solution of ¯ ¯ (1 − ν ∗ ) S − (1 + λ) β − e(ν ∗ ) + ψ(¯(ν ∗ )) e = λν ∗ Φ(¯(ν ∗ )).(¯. for each i ˆ ψ (ei ) = 1 ψ (¯i ) = 1 − e Let ei (ˆi ) = Z ¯ ν νi ˆ 1−ˆi ν νi ˆ λ · · Φ (¯i ). with Φ(e) = ψ(e) − ψ(e − Δβ). hence. the solution is: e ψ (e) = 1 .The same analysis as in 1 can be made for each signal σi with the posterior probabilities νi instead of ν.U ).

Therefore Z is concave if Z ≤ 0. Boyer and Laﬀont (2003). ψ > 0. the incentives increase (since ψ (ei ) = 1) when the ﬁrm is active. 1 {β} = 0 if β = β. Z(·) is a decreasing function. Hence Z ˆ Z is concave if ψ is quadratic or λ small enough. νi ˆ 1 − νi ˆ . Then incentives decrease ˆ (increase) for a favorable (defavorable) signal. incentives increase with the availability of the information structure. Since. I. Now. i = 1. i. . h(ˆi ) ≡ 1−ˆi is an increasing ν ν ˆ = Z h 2 + Z h . So. on the other hand incentives increase when the signal is unfavorable. the expected power of incentives decreases if the regulator has access to the information structure I and there is never shutdown after σi . . by the low of iterated expectations. νi ˆ Since ψ > 0. I From Jensen’s inequality ˆ ν Eσi ei (ˆi ) ≤ e(ν) if Z(ˆi ) ≡ Z ¯ ν ¯ is concave. Note that ˆ convex function. ν Say that a signal is favorable (defavorable) if νi > ν(ˆi < ν).112 SOLUTIONS ¯ I where 1 {β} = 1 if β = β. .e. . if after each favorable signal νi∗ > ν ∗ . the regulator shuts down the ineﬃcient ﬁrm.. .

q2 )q1 − p2 (q1 . q )q = c ∂q 2 1 2 1 ¯ S + θ¯2 + λ q ∂p1 ¯ ¯ (¯1 . q2 )q2 − (1 + λ)t ˆ where t is the gross transfer to the ﬁrm. The fringe’s utility is U F = p2 (q1 . q ¯ q ∂q 2 . q )q + p1 (q 1 .Optimal regulation is characterized by the solution of max ν S(q 1 + q 2 ) + θq 1 q 2 + λp1 (q 1 . Social welfare is V + U + U F = S(q1 + q2 ) + θq1 q2 + λp1 (q1 . Hence the ﬁrst-order conditions e e e ψ (e) = q 1 ψ (¯) = q1 − e ¯ S + θq 2 + λ λ ν e Φ (¯) 1+λ1−ν = (1 + λ)(β − e) ∂p1 (q .113 Competitive Pressure and Incentives 1. q2 )¯1 + p1 (¯1 .Consumers’ utility is ˆ V = S(q1 + q2 ) + θq1 q2 − p1 (q1 . q2 )q2 − cq2 . q2 )¯1 = c. q2 ) q ¯ q q ¯ = (1 + λ)(β − e) ∂ q1 ¯ ∂p1 ¯ S + θ¯1 + λ q (¯1 . q 2 )q 1 − (1 + λ)((β − e)q 1 + ψ(e)) − cq 2 − λU ¯ ¯q ¯ ¯ q ¯ q ¯ q e q +(1 − ν) S(¯1 + q2 ) + θ¯1 q2 + λp1 (¯1 . q2 )¯2 − (1 + λ)((β − e)¯2 + ψ(¯)) − c¯2 − λU q subject to ¯ e U ≥ U + Φ(¯) ¯ U ≥ U − Φ(e + Δβ) U ≥ 0 ¯ U ≥ 0. q 2 ) ∂q 1 1 2 1 S + θq 1 + λ ∂p1 (q . The monopoly’s utility is ˆ U = t + p1 (q1 . q2 )q1 − (1 + λ)((β − e)q1 + ψ(e)) − cq2 − λU. q2 )q1 − (β − e)q1 − ψ(e) ≡ t − ψ(e). 2. with Φ(¯) = ψ(¯) − ψ(¯ − Δβ).

114 SOLUTIONS ¯ 3. de dθ If they are strategic substitutes. If goods are strategic complements S +θ+λ then de dθ ∂ 2 p1 ∂p1 q1 + ∂q1 ∂q2 ∂q2 > 0. S + λ ∂∂qp21 q1 is negative from the second-order condition. for both types de 1 = dc D Sign de dc S +θ+λ ∂ 2 p1 ∂p1 q1 + ∂q1 ∂q2 ∂q2 = − Sign (S + θ + λ(S q1 + S + θ)).For both types we have de 1 = −q1 S + θ + λ dθ D 2 2 < 0. de dc If goods are strategic substitutes (S q1 + S + θ) < 0 then > 0. Diﬀerentiating these systems we have with the determinant D < 0. > 0.We have two sets of 3 equations (one for β = β and one for β = β). de dc If goods are strategic complement (S q1 + S + θ) > 0 and λ is large enough 4. the substitution eﬀect may dominate and Boyer and Laﬀont ( 2003). . ∂ 2 p1 ∂p1 q1 + ∂q1 ∂q2 ∂q2 + q2 ∂ 2 p1 S + λ 2 q1 ∂q2 . < 0.

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