Lecture 2: Monopolistic Screening

ECON 813

Shota Ichihashi
 Principal-Agent Models

Principal-agent models:
Principal designs a mechanism (“contract) for agent to join.

Key distinction:
I Agent acquires private information after contracting
→ moral hazard (previous lectures)
I Agent has private info before (or at time of) contracting
→ screening/adverse selection models

This week: monopolistic screening.

Next week: adverse selection/signaling/screening in competitive

environment.
 Screening with 2 Types

Monopoly seller faces continuum of buyers.

Every buyer has type θ ∈ {θL , θH }, 0 < θL < θH .

Fraction β are type θL , fraction 1 − β are type θH .
Type θ buyer gets utility θv(q) from consuming q units of good. v(0) = 0,
v0 > 0, and v00 ≤ 0.

Seller has linear production cost c.

Seller maximizes profit subject to giving each buyer type non-negative
payoff.

Example: airline tickets. Business travelers have high value, leisure

travelers have low value. (q can be quality)
 Selling Mechanism and the Revelation Principle

What selling mechanism should the seller use?

Example 1: Set fixed price p, offer to sell any quantity at price p.

(Each buyer, knowing type θ , chooses quantity q and pays pq.)

Example 2: Up to quantity q, price p1 per unit; above q, price p2 per unit.

Example 3: Buyers report whether θ > 1/2. If θ > 1/2, Example 1 will be
offered. Otherwise, Example 2 will be offered.

Random prices, negotiating prices over multiple periods. . .

The set of possible selling mechanisms is large!

Revelation principle helps.

 Selling Mechanism and the Revelation Principle

Revelation principle (informal): For every selling procedure, there is an

incentive compatible direct selling mechanism that results in the same
outcome.

(Informal: we don’t define the set of all selling procedures in this class.)

Direct mechanism (q, t)

I Buyers report their types θ .
I Buyer obtains quantity q(θ) and pays t(θ).

(q, t) is incentive compatible if it is optimal for buyer to report his true

type θ .
 Revelation Principle: Idea

Take any mechanism (selling procedure).

Buyer, knowing θ , acts optimally in the mechanism

→ let (q(θ), t(θ)) denote the resulting quantity and price.

Consider the following direct mechanism:

Buyer reports his type. If the buyer reports θ 0 , she gets (q(θ 0 ), t(θ 0 )).

The mechanism is incentive-compatible:

If buyer has type θ , she would report θ .

Why? If the buyer would benefit from “lying,” then in the original
mechanism, she would have acted like some θ 00 6= θ , which is a
contradiction.
 Screening with 2 Types

Under two types (θL and θH ), a direct mechanism specifies (tL , qL , tH , qH ).

First-best: choose (tL , qL , tH , qH ) to maximize profits subject to individual

rationality constraints (=participation constraints).

Second-best: choose (tL , qL , tH , qH ) to maximize profits subject to

individual rationality constraints and incentive-compatibility constraints.
 Complete Information Benchmark
The first-best: Seller can observe buyers’ types.

Problem is then just to maximize profit subject to participation constraints.

max β(tL − cqL ) + (1 − β)(tH − cqH )

qL ,tL ,qH ,tH

subject to
(IRH) θH v(qH ) − tH ≥ 0
(IRL) θL v(qL ) − tL ≥ 0.

We require IR (= Individual Rationality) for each type.

IR constraints bind at the optimum (every buyer pays exactly what the
allocation worth to her).

Substitute transfers out of objective to get

max β(θL v(qL ) − cqL ) + (1 − β)(θH v(qH ) − cqH ).

qL ,qH
 Complete Information Benchmark

max β(θL v(qL ) − cqL ) + (1 − β)(θH v(qH ) − cqH ).

qL ,qH

Solution is

qL = qFB FB FB FB
L , tL = θL v(qL ), qH = qH , tH = θH v(qH ),

where qBF
i is given by
θi v0 (qFB
i ) = c.

Each buyer type gets its first-best allocation, seller extracts entire first-best
surplus.

Seller offers different contract to each type of buyer.

 Incomplete Information
Suppose the seller can’t observe buyers’ types.

Can the seller still extract first-best surplus?

Suppose seller asks each buyer to report θ , then offers (qFB FB
i , θi v(qi )).

θL buyers: If reveals truthfully, gets payoff 0.

If take contract intended for θH buyers, get payoff
θL v(qFB FB
H ) − tH < θH v(qH ) − tH = 0.

So θL buyers will reveal truthfully.

θH buyers: If reveal truthfully, get payoff 0.

If take contract intended for θL buyers, get payoff
θH v(qFB FB
L ) − tL > θL v(qL ) − tL = 0.

So θH buyers will not reveal truthfully.

 Incomplete Information

If seller offers first-best contracts, both types of buyers take contract

intended for θL buyers.

Seller cannot get first-best profit when buyer types are unobservable.

What’s the best the seller can do here?

This is the optimal screening problem.

 Optimal Screnning

Revelation principle: Seller can WLOG restrict attention to incentive

compatible direct mechanisms.

max β(tL − cqL ) + (1 − β)(tH − cqH )

qL ,tL ,qH ,tH

subject to
(ICH) θH v(qH ) − tH ≥ θH v(qL ) − tL
(ICL) θL v(qL ) − tL ≥ θL v(qH ) − tH
(IRH) θH v(qH ) − tH ≥ 0
(IRL) θL v(qL ) − tL ≥ 0.

The first-best solution violates ICH, so it is not incentive compatible.

 Optimal Screnning

We cover a standard procedure for solving 2-type optimal screening

problems.

We break procedure into 5 steps.

 Step 1: IRH is Slack

IRH slack = if we solve the problem without IRH, the solution satisfies IRH

Why? So long as we have other constraints (ICH, ICL, IRL):

 Step 1: IRH is Slack

IRH slack = if we solve the problem without IRH, the solution satisfies IRH

Why? So long as we have other constraints (ICH, ICL, IRL):

θH v(qH ) − tH ≥ θH v(qL ) − tL (by ICH)

 Step 1: IRH is Slack

IRH slack = if we solve the problem without IRH, the solution satisfies IRH

Why? So long as we have other constraints (ICH, ICL, IRL):

θH v(qH ) − tH ≥ θH v(qL ) − tL (by ICH)

≥ θL v(qL ) − tL (by θH > θL )
 Step 1: IRH is Slack

IRH slack = if we solve the problem without IRH, the solution satisfies IRH

Why? So long as we have other constraints (ICH, ICL, IRL):

θH v(qH ) − tH ≥ θH v(qL ) − tL (by ICH)

≥ θL v(qL ) − tL (by θH > θL )
≥ 0 (by IRL).
 Step 1: IRH is Slack

IRH slack = if we solve the problem without IRH, the solution satisfies IRH

Why? So long as we have other constraints (ICH, ICL, IRL):

θH v(qH ) − tH ≥ θH v(qL ) − tL (by ICH)

≥ θL v(qL ) − tL (by θH > θL )
≥ 0 (by IRL).

Thus we can drop IRH from the problem.

 Step 2: Conjecture that ICL is Slack

There is no “proof” for this, but it is a natural conjecture as ICL is satsified

at first-best solution = If the seller offers (qFB FB FB FB
L , tL , qH , tH ), type θL takes
the “right” contract.

We must come back later and prove that this conjecture is correct.
 Step 3: ICH and IRL Bind Once Eliminate IRH and ICL

The problem without IRH and ICL:

max β(tL − cqL ) + (1 − β)(tH − cqH )

qL ,tL ,qH ,tH

subject to
(ICH) θH v(qH ) − tH ≥ θH v(qL ) − tL
(IRL) θL v(qL ) − tL ≥ 0.

We show that both constraints bind at the optimum.

Proof that ICH binds: Otherwise, increase tH . This increases objective and
does not affect IRL.

Proof that IRL binds: Otherwise, increase tL . This increases objective

while maintaining ICH.
 Step 4: Substitute out tL and tH and Solve
Binding IRL an ICH give

tL = θL v(qL )
tH = θH v(qH ) − θH v(qL ) + tL = θH v(qH ) − (θH − θL )v(qL ).

Objective β(tL − cqL ) + (1 − β)(tH − cqH ) becomes

max β(θL v(qL ) − cqL ) + (1 − β)(θH v(qH ) − (θH − θL )v(qL ) − cqH ).

qL ,qH

Gives first-order conditions wrt qH and qL

θH v0 (qH ) = c (1)
 
1−β
θL − (θH − θL ) v0 (qL ) = c. (2)
β
Optimal qH is given by (1).
Optimal qL is given by (2) if the solution exists; otherwise, qL = 0.
 Step 5: Check that ICL is Satisfied

We dropped ICL based on the conjecture that it would be slack; now we

have to prove it.

ICH binding, so we have

θH v(qH ) − tH = θH v(qL ) − tL
⇒θH [v(qH ) − v(qL )] = tH − tL
⇒θL [v(qH ) − v(qL )] ≤ tH − tL (as θH > θL )
⇒θL v(qH ) − tH ≤ θL v(qL ) − tL .

Thus ICL holds.

 Interpreting the Solution: Transfer

tL = θL v(qL )
tH = θH v(qH ) − (θH − θL )v(qL ).

tL equals low type’s value for what he consumes.

Seller extracts all surplus from selling to low type.

tH does not equal high type’s value for what he consumers.

Difference (θH − θL )v(qL ) is high type’s information rent.

Seller cannot extract all surplus from selling to high type.
 Interpreting the Solution: Quality

θH v0 (qH ) = c
c
θL v0 (qL ) =  .
1−β θH −θL
1− β θL

qH equals first-best level, qFB

H .

qL < qFB
L , because high-type’s information rent is increasing in qL .
1−β
Gap between qL and qFB L increases in β as reducing high types’
information rent is more important when high types are relatively more
prevalent.

Gap between qL and qFB

L increases in θH as high types’ information rent
increases with θH .
 General Insights

Every buyer type except for lowest one receives positive information rent,
which is increasing in allocations of lower types.

Allocation of every buyer type except for highest one is distorted

downward from the firs-best level, and size of distortion is increasing in
mass of higher types.

We confirmed these insights in a 2-type case. We now study a continuum

of types.
 Screening with Continuum of Types

Suppose θ is distributed on [θ, θ] ⊂ R+ with positive density f (θ).

Why do we consider continuum types?

I See how insights from 2-type model generalize.
I Learn new economic concepts such as
local incentive compatibility and virtual values.
I Get clearer intuition with help of Envelope Theorem.
 Screening with Continuum of Types

Revelation Principle: Seller can use a direct mechanism (q(·), t(·)).

Seller’s problem:
Z θ
max (t(θ) − cq(θ))f (θ)dθ
q(·),t(·) θ

subject to
(ICθ ) θv(q(θ)) − t(θ) ≥ θv(q(θ 0 )) − t(θ 0 ), ∀θ, θ 0 ∈ [θ, θ]
(IRθ ) θv(q(θ)) − t(θ) ≥ 0, ∀θ ∈ [θ, θ].
 Simplifying IR Constraints

(IRθ ) θv(q(θ)) − t(θ) ≥ 0, ∀θ ∈ [θ, θ].

Only IRθ binds:

θv(q(θ)) − t(θ) ≥ θv(q(θ) − t(θ) (by ICθ)

≥ θv(q(θ) − t(θ) (by θ > θ)
≥ 0 (by IRθ).

IR constraints become θv(q(θ)) − t(θ) ≥ 0.

 Remark on “Almost Everywhere”
Hereafter, we use the notion “f : R → R satisfies a property for almost
every x ∈ R” ⇐⇒ The property holds except on a subset that has
(Lebesgue) measure zero.

Not differentiable everywhere, but

differentiable almost everywhere

1. Some property holds “almost everywhere” but not everywhere. E.g. a

monotone function on (a, b) is differentiable almost everywhere.
2. “Almost everywhere” doesn’t matter once we take integration. E.g. if
Ra
f (x) > 0 for almost every x ∈ (a, b), then b f (x)dx > 0, even
though f (y) < 0 may hold for some y.
 Simplifying IC Constraints

Lemma
An allocation (q(θ), t(θ))θ∈[θ,θ] satisfies all IC constraints if and only if q
and t are differentiable (almost everywhere) and satisfy the following two
conditions:

Monotonicity: q0 (θ) ≥ 0 for (almost) all θ ∈ [θ, θ].

Local incentive compatibility: θv0 (q(θ))q0 (θ) = t0 (θ) for (almost) all
θ ∈ [θ, θ].

Local IC is the FOC for θ 0 in maxθ0 θv(q(θ 0 )) − t(θ 0 )

 IC ⇒ Monotonicity + Local IC
Suppose all IC constraints hold.
Then for all θ > θ 0 ,

θv(q(θ)) − t(θ) ≥ θv(q(θ0 )) − t(θ0 )

θv(q(θ0 )) − t(θ0 ) ≥ θv(q(θ)) − t(θ).

Sum up inequalities, cancel transfers, rearrange to get

(θ − θ0 )v(q(θ)) ≥ (θ − θ0 )v(q(θ0 )). (3)

Dividing by θ − θ 0 > 0 gives monotonicity (key: single-crossing)

q monotone ⇒ q differentiable almost everywhere
Thus t is differentiable almost everywhere, by IC.
Once we know q and t are differentiable, the FOC with respect to θ 0 in
maxθ0 θv(q(θ0 )) − t(θ0 ) gives local IC
 Monotonicity + Local IC ⇒ IC

Suppose θ > θ 0 . We want to prove

θv(q(θ)) − t(θ) − [θv(q(θ0 )) − t(θ0 )] ≥ 0.

Rθ
Take g(x) = θv(q(x)) − t(x) and recall g(θ) − g(θ 0 ) = θ0 g0 (x)dx

θv(q(θ)) − t(θ) − [θv(q(θ0 )) − t(θ0 )]

Z θ
= (θv0 (q(x))q0 (x) − t0 (x))dx
θ0
Z θ
≥ (xv0 (q(x))q0 (x) − t0 (x))dx (as θ ≥ x and q0 (x) ≥ 0)
θ0
= 0.

This case of θ 0 < θ is symmetric.

 Rewrite Seller’s Problem

Z θ
max (t(θ) − cq(θ))f (θ)dθ
q(·),t(·) θ

subject to
(MONO) q0 (θ) ≥ 0, ∀θ ∈ [θ, θ]
(LIC) θv0 (q(θ))q0 (θ) = t0 (θ), a.e. θ ∈ [θ, θ]
(IRθ ) θv(q(θ)) − t(θ) ≥ 0.
 Further Simplifying LIC

Lemma
Take any allocation (q, t) and define

U(θ) = θv(q(θ)) − t(θ). (4)

Local incentive compatibility (θv0 (q(θ))q0 (θ) = t0 (θ)) is equivalent to

Z θ
U(θ) = U(θ) + v(q(x))dx, ∀θ. (5)
θ

Payoff equivalence: Holmstrom’s lemma/Myerson’s lemma

 Further Simplification
Take any allocation (q, t) and define

U(θ) = θv(q(θ)) − t(θ). (6)

Proof.
Suppose (q, t) satisfies LIC. By differentiating U(θ), we obtain

U 0 (θ) = v(q(θ)) + θv0 (q(θ))q0 (θ) − t0 (θ)

= v(q(θ)). (due to LIC)

Integrating both sides from θ to θ , we obtain

Z θ
U(θ) = U(θ) + v(q(x))dx, ∀θ. (7)
θ

Conversely, differentiating both sides in θ , we obtain LIC.

 Rewrite Seller’s Problem

Z θ
max (t(θ) − cq(θ))f (θ)dθ
q(·),t(·) θ

subject to
(MONO) q0 (θ) ≥ 0, ∀θ ∈ [θ, θ]
Z θ
(LIC) θv(q(θ)) − t(θ) = U(θ) + v(q(x))dx, ∀θ ∈ [θ, θ]
θ

(IRθ ) U(θ) = θv(q(θ)) − t(θ) ≥ 0.

 Rewrite Seller’s Problem

IRθ binds, so U(θ) = 0

Rθ
Substitute LIC t(θ) = θv(q(θ)) − θ v(q(x))dx out of objective to get

Z θ  Z θ 
max θv(q(θ)) − v(q(x))dx − cq(θ) f (θ)dθ. (8)
q(·) θ θ

The integration by parts implies

Z θ Z θ  Z θ
v(q(x))dx f (θ)dθ = v(q(θ))[1 − F(θ)]dθ.
θ θ θ

Thus we can rewrite (8) as

θ  
1 − F(θ)
Z
max θv(q(θ)) − v(q(θ)) − cq(θ) f (θ)dθ. (9)
q(·) θ f (θ)
 Rewrite Seller’s Problem

IRθ binds, so U(θ) = 0

Rθ
Substitute LIC t(θ) = θv(q(θ)) − θ v(q(x))dx out of objective to get

Z θ  Z θ 
max θv(q(θ)) − v(q(x))dx − cq(θ) f (θ)dθ. (8)
q(·) θ θ

The integration by parts implies

Z θ Z θ  Z θ
v(q(x))dx f (θ)dθ = v(q(θ))[1 − F(θ)]dθ.
θ θ θ

Thus we can rewrite (8) as

θ  
1 − F(θ)
Z
max θv(q(θ)) − v(q(θ)) − cq(θ) f (θ)dθ. (9)
q(·) θ f (θ)
 Solve Seller’s Problem

θ  
1 − F(θ)
Z
max θv(q(θ)) − v(q(θ)) − cq(θ) f (θ)dθ. (10)
q(·) θ f (θ)

Maximize over q(θ) point-wise:

 
1 − F(θ) 0
θ− v (q(θ)) = c.
f (θ)

1−F(θ)
If we ignore f (θ) , q(θ) = qFB (θ) (marginal benefit = marginal cost)

Instead, seller sets marginal benefit = marginal cost as if agent’s true value
1−F(θ)
were θ − f (θ) rather than θ
1−F(θ)
θ− f (θ) is called type θ 0 is virtual value (or virtual type)
 Virtual Value

Why does seller care about virtual value instead of true value?

1−F(θ)
Answer: f (θ) term is marginal cost to seller of increasing type θ ’s
allocation in terms of information rents that must be given to higher-value
buyers.
 Virtual Value

Type θ0 ’s information rent is

Z θ0
U(θ0 ) = v(q(θ))dθ. (11)
θ

Marginal increase in q(θ) increases information rent of every higher type

by v0 (q(θ)) (otherwise, any higher type may pretend to be a lower type)

Total marginal increase in information rents:(1 − F(θ))v0 (q(θ)).

Marginal increase in surplus from selling to type θ : (θv0 (q(θ)) − c)f (θ)

Setting marginal increase in information rent equal to marginal increase in

surplus from selling to type θ gives solution.
 Monotonicity

Must check that monotonicity (= q(θ) increasing) holds.

Recall that q(θ) (if positive) solves

 
1 − F(θ) 0
θ− v (q(θ)) = c.
f (θ)

1−F(θ)
Holds if θ − f (θ) is non-decreasing
(non-decreasing virtual values, “regular” case)
f (θ)
Sufficient condition: non-decreasing hazard rate 1−F(θ)

Satisfied for uniform, normal, exponential distributions.

If virtual values decrease over some interval, need to “iron out” solution to
make it monotonic (not covered in this class)
 Summary

Optimal screening with 2 types and continuum of types.

Every buyer type except for lowest one receives positive information rent,
increasing in allocations of lower types.

Allocation of every buyer type except for highest one is distorted

downward from first-best level, size of distortion is increasing in mass of
higher types

With continuum of types, distortion in allocation is given by maximizing

social surplus with respect to virtual values rather than true values (if
virtual values are monotone)