Microeconomics Focusing on the trivial case θ ∗ = [θ, θ] the outcome is inefficient as productivi- more comprehensive game theoretic employment

prehensive game theoretic employment at the highest wage in com-

Mattia Albertini, Page 1 di 2 with w∗ = E[θ] then, if E[θ] ≥ r all ac- ty is E[θ|r(θ) ≤ w] which is less than the approach: Suppose there are two firms petitive equilibrium, that is, w3∗ . Since
cepts, if E[θ] < r none accepts. public E[θ] productivity, moreover there in the market playing the following this is the highest worker type, w3∗ = r(θ ∗ )
1 Akerlof Model Inefficiency: With respect to the public is adverse selection because in the public sequential game,
• Stage 1: Firms simultaneously announ- and also w3∗ = E[θ|θ ≤ θ ∗ ] thus,
Set up case, there is either too much employ- case all should work.
The Akerlof model is characterized by ment or no employment. Adverse Selection: Pathological Cases ce the wage offers;
firms (demand side): Adverse selection may lead to more pa- • Stage 2: workers decide whether to r(θ ∗ ) = E[θ|θ ≤ θ ∗ ]
Adverse Selection: Non constant r(θ) work, and if so, in which firm (if indif-
• Identical and price taking; If r(θ) varies with θ Adverse Selection: thological cases depending on distributi-
• CRTS technology; on F(θ). Consider two pathological cases, ferent randomize evenly among firms). Hence wu (θ ∗ ) = 0 and we (θ ∗ ) = r(θ ∗ ).
even if every worker type should work, In this stage game we can use the solu- Thus, the outcome is the same as in the
• Use only labour as input; the market fails.
and workers (supply side): tion concept of SPNE: In the last figure, competitive equilibrium without market
To see this, suppose that for all θ: w1∗ , w2∗ , w3∗ are all NE, but w3∗ is the only intervention, hence there is no Pareto im-
• N workers, each differs in number of
units produced, i.e. productivity θ ∈ • r(θ) ≤ θ: In the public case, everyone SPNE. provement .
should work. Proof: In all the three NE firms make ze- b < θ ∗ , then r(θ ∗ ) > r(θ)
[θ, θ] ∼ F(·); • r(·) strictly increasing: workers more Case 2: Suppose θ b
• Worker choose to work at home and productive in a firm are more produc- ro profits. However, if the wage were less thus, using the conditions above,
earn r(θ) or to work in a firm and re- tive also at home. than w3∗ any of the two firm could earn
ceive w; positive profits by setting w3∗ − ε. Hence
h i
in equilibrium the Private Competitive b − r(θ ∗ ) ≤ F(θ)
we (θ) b − r(θ ∗ )
b E[θ|θ ≤ θ]
A worker chooses to work for a firm iff, Equilibrium must satisfy The left figure displays a situation where w1∗ and w2∗ are unreasonable NE, and w3∗
r(θ) ≤ w r(θ) = θ and r(θ) < θ for all other θ (the is the unique SPNE.
Θ ∗ = {θ : r(θ) ≤ w∗ } function is always below the 45o ) line. but since r(θ ∗ ) = E[θ|θ ≤ θ ∗ ] then we (θ)−
b
Intervention: Constrained Efficiency
∗ ∗ The equilibrium wage is w∗ = θ, hence r(θ ∗ ) ≤ 0. Hence the type θ are for sure
w = E[θ|θ ∈ Θ ] Assume a social planner/government in- worse off by the intervention as they re-
Public Competitive Equilibrium only the worker with θ is driven in the tervenes into the market: in the previous
Profit maximization implies, market, but everyone should work given figure, can the government do better than b which is less than w∗ = r(θ ∗ )
ceive we (θ)
or also, 3
r(θ) < θ in the social optimum (public w3∗ in equilibrium? No. which is what would receive in equilibri-
w(θ) = θ ∀θ ∗ ∗ equilibrium). um without the intervention. Hence there
w = E[θ|r(θ) ≤ w ] Proof: Suppose the planner runs the firm
And thus the set of workers is, The right figure we display a case with is no Pareto improvement.
himself (firms will then earn zero profits
we can graph the function multiple equilibria, a case that for so- in equilibrium so is the same) and that Case 3: Suppose θ b > θ ∗ . Then from the
{θ : r(θ) ≤ θ} E[θ|r(θ) ≤ w] as a function of w, me F(θ), as E[θ|r(θ) ≤ w] has no slope cannot distinguish workers. The plan- figure we know that E[θ|r(θ) ≤ w] < w
note for publicly observable, the wage
constraints. Firms earn zero profit in ner offers we to those employed and wu for w > w3∗ . Thus, since r(θ ∗ ) = w∗ and r
each equilibria but are not all socially to those unemployed (a subsidy on top is strictly increasing, we have,
depends on θ, hence w = w(θ). This is the desirable: absence of coordination may
Pareto Efficient case. of r(θ)). Suppose that the social planner
lead to equilibrium at lower wage, with wants to implement an outcome in which
Private Competitive Equilibrium less efficient workers and lower wages, b = E[θ|θ ≤ θ]
E[θ|r(θ) ≤ r(θ)] b
If productivity is not observable w is con- hence multiple equilibria can be Pareto the target worker θ ≤ θ b ∈ [θ, θ] accept
stant, i.e. does not depend on θ becau- Ranked. employment, which we assume accepts
if indifferent. Hence, we have two cons- so E[θ|θ ≤ θ] b for all θ
b < r(θ) b > θ ∗ . Thus
se firms cannot distinguish workers. The Game approach - à la Bertrand
competitive (Akerlof) equilibrium is gi- traints: implying that wu (θ) < 0 for all θ b > θ∗ .
So far no competitive behavior was indu-
b
∗
ven by the a set of workers Θ and a wage • Let θ b = θ ∗ the highest worker that ac-
ced, i.e. the outcome of the equilibrium Hence type θ workers are made worse off
rate w∗ , was not considered as the result of a ga- cepts employment in w3 (highest wage by the intervention, i.e. no Pareto impro-
me, but rather as an analytical approach equilibrium). For this worker vement.
Θ ∗ = {θ : r(θ) ≤ w∗ }
as proposed by Akerlof. That is, in figure • Indifference: Worker θ b accepts at, In sum we say that the highest competiti-
w∗ = E[θ|θ ∈ Θ ∗ ] ve equilibrium wage in this case, that is
On the vertical axis we plot the expec- w3∗ is constrained efficient.
wu + r(θ)
b = we
ted/average productivity of workers 2 Spence Model of Signalling
Special Case: r(θ) = r from the point of view of the firm, on the
Suppose r(θ) = r for all θ and F(θ ≤ r) ∈ horizontal axis the wage being paid. The Set Up
• Budget Balance: Average cost of the The idea of the model is that workers can
(0, 1) so that either θ > r or θ < r for every minimum is when only θ work (when worker equals the expected efficiency,
worker. workers can ßignal"their ability to em-
If public the wage depends on θ, and gi- w = r(θ)), the maximum when all [θ, θ] Z θb ployers through the level of education
acquired. Consider a model in which:
ven CRTS (linear) w(θ) = θ. Thus, wor- work (when w ≥ r(θ)), thus achieves the b + wu (1 − F(θ))
we F(θ) b = θf (θ)dθ • Two CRTS firms;
kers accept if θ ≥ r or reject if θ < r. max at E[θ] and then for any other wage θ • Two types θL > θH , where λ = P(θ =
If private the wage is constant w. Hence, stay constant. Note:
o θH );
since home productivity is constant, eit- • If it is above the 45 line w < assuming the pdf f (·) exists. • Workers can get education e, (here has
her all accept w ≥ r or all reject w < r. E[θ|r(θ) ≤ w]: wages are lower than Combining the two and noting that
the productivity, firms make positive no intrinsic value, so does nothing for
Thus, the competitive equilibrium is de- R θb
productivity);
fined by, profits while workers want to exit; θf (θ)dθ = F(θ)E[θ|θ
b b then,
≤ θ]
• If it is below the 45o line w > θ • Education e for agent θ comes at a cost
( E[θ|r(θ) ≤ w]: wages are higher than h i c(e, θ).
[θ, θ] wu (θ)
b = F(θ)
b E[θ|θ ≤ θ]b − r(θ)
Θ ∗ = {θ : r(θ) ≤ w∗ } = the productivity, firms make negative with the Akerlof definition of equilibri- 1. c(0, θ) = 0;
b
∅ profits while workers enters; um we would rule out w0 because firms h i 2. ce (e, θ) > 0 and cee (e, θ) > 0: cost is
( If intersect, then the condition of compe- at that wage attract more productive wor- we (θ)
b = F(θ)
b E[θ|θ ≤ θ] b + r(θ)
b − r(θ) b
increasing and convex in education;
E[θ|[θ, θ]] = E[θ]
w∗ = titive equilibrium is realized ker and since E[θ|r(θ) ≤ w0 ] > w0 would 3. cθ (e, θ) < 0: the same level of e is
E[θ|∅] = E[θ] assumption Case 1: Now, suppose that we target the
make positive profits. However, we can less costly for high types than for
w∗ = E[θ|r(θ) ≤ w∗ ] prune equilibria also by considering a b = θ ∗ who accepts
highest worker type θ low types.
 Microeconomics
Mattia Albertini, Page 2 di 2
4. ceθ (e, θ) < 0: Spence-Mirlees sin-
gle crossing condition, that is, the
marginal cost of e decreases as we
increase the type θ.
• Utility of worker θ is, u(w, e|θ) = w −
c(e, θ);
• The opportunity cost of working home
is r(θ).
Focus on r(θH ) = r(θL ). We know that
in absence of signalling, a constant r im-
plies w = E[θ], which is Pareto efficient.
Thus, we can analyze the inefficiencies of
introducing signalling.
Stages of the Game
The game goes as follow:
1. Nature selects the worker type (H or
L), which is privately observed;
2. The worker chooses education level e;
3. Both firms observe e and make wage
offers;
4. The worker decides which offer to ac-
cept (if any).
Firms make beliefs on the worker’s type
when they observe the education level.
We indicate these with µ(e), that is, the
ßubjective"probability that the worker ty-
pe is a high type. With beliefs, the so-
lution concept that usually is applied is
of Perfect Bayesian Equilibrium (PBE):
A set of strategies and a belief function
µ(e) ∈ [0, 1] is a PBE if,
• The worker’s strategy is optimal given
firm’s strategies;
• The beliefs µ(e) follows Bayes rule;
• The firm’s wage offers given each e con-
stitute a NE.
Note that we can solve for the equilibri-
um wage of this game by backward in-
duction: Suppose the worker accepts. The
firm after seeing e, firms make beliefs
µ(e), therefore the expected productivity
of the worker for the firm is believed to be
µ(e)θH + (1 − µ(e))θL . Because both firms
have same beliefs and thus offer the same
wage and in equilibrium we know that
the wage must equal the expected pro-
ductivity (otherwise with positive profits
there are incentives to deviate), then the
equilibrium wage is,
w∗ (e) = µ(e)θH + (1 − µ(e))θL
2.1 Preference map and Wage schedule
Preference Map: We can represents
the utility functions u(w, e|θ) =
w − c(e, θ) for increasing values
of e and w given θH or θL ,
Note that the two indifference curves equilibria that can arise: separating or e∗ (θL ) = 0.
intersects only once: this is due to the pooled equilibrium.
Spence-Mirlees single crossing property Separating Equilibria
ceθ (e, θ) < 0. In other words, the slope of A separating equilibria arises when the completely free to choose µ(e) in the in-
the indifference curve at any pair (w, e) two worker types∗ choose different
for a constant utility level is,
!
dw
u = w − c(e, θ) ⇒ = ce (e, θ)
de u
where u is any constant (i.e. 0). Therefore
the single crossing implies that the indif-
ference curve of the high type is always
flatter than the one of the low type be-
cause the marginal costs of education are
smaller by assumption. This is the funda-
mental assumption that allows signal to
work, i.e. education can serve as a signal
because marginal costs of education de-
pends on a worker’s type: this may drive
a wedge between the educational choices • In any separating PBE,
of type L and type H which may find of
different importance to get an education.
As a result firm can regard to educational
level as a signal of worker quality.
Wage Schedule: Since in any PBE we
know the wage for any choice of e is,
w(e) = µ(e)θH + (1 − µ(e))θL
then w(e) ∈ [θL , θH ] for all
values of e. This gives rise
to a wage schedule as follow, Now
where the path depends on the firms’ Note the low type chooses e∗ (θL ) = 0 and gure above, the educational level of
beliefs. Notice that the wage schedule gets paid w∗ (e∗ (θL )) = θL . On the other high type needs not to be unique:
w(e) = µ(e)θH + (1 − µ(e))θL is always hand, the the high type chooses e∗ (θL ) = ẽ any educational level in (ẽ, e1 ] can be
maximized at µ(e) = 1 and minimized and gets paid w∗ (e∗ (θH )) = θH . To see supported as an equilibrium.
at µ(e) = 0. Alternatively, for a fixed that this constitute exactly a separating • If high types choose e(θH ) < ẽ then
level of wage w∗ (e) we can derive the equilibrium, note that firms are comple- low type would prefer to deviate and
corresponding beliefs from the equation tely free to have any beliefs µ(e) and offer choose e(θL ) = e(θH ) and get θH ,
above as, any wage w(e) off the equilibrium path, which would guarantee a higher uti-
i.e. for e , 0, ẽ, and therefore the wage lity. Hence, below ẽ there cannot be a
∗
w (e) − θL NE;
µ(e) = schedule varies arbitrarily in the interval
θH − θL (0, +∞)\ẽ. However, on the equilibrium • If high type chooses e(θH ) > e1 then the
path we must have µ(ẽ) = 1 and µ(0) = 0, utility would be lower than the utility
note that for w∗ (e) = θH µ(e) = 1 and and these beliefs on the equilibrium if the high type would deviate below
w∗ (e) = θL µ(e) = 0. e1 because the wage has a maximum
path corresponds to w∗ (e∗ (θH )) = θH already at θH , and thus any additional
We now consider separately the type of and w∗ (e∗ (θL )) = θL for e∗ (θH ) = ẽ and cost in education is not remunerated.
Even if the equilibrium educational level
Now, we want to remark once again that of the high type supports an equilibrium
since off equilibrium path the firms are in e(θH ) ∈ [ẽ, e1 ], we can Pareto rank the
equilibria in this interval:
educa- terval (0, +∞)\ẽ also the following wage For the firms there is no preference of an
tion levels. Let e (θ) and w∗ (e) the equi- schedule w(e) supports the equilibrium equilibrium as in every point they make
librium education of worker and wage
0 profits as the product of each worker is
offer by firm. Now we can establish two
θi for i = H, L and the cost (the wage) is
simple but important results: exactly θi i = H, L
• In any separating PBE,
For the workers the high type always
prefers that in equilibrium e(θH ) = ẽ as
w∗ (e∗ (θH )) = θH and w∗ (e∗ (θL )) = θL the vertical distance between the indif-
In fact, at the PBE, beliefs must be cor- ference curve and the horizontal line
rectly derived by Bayes Rule. Hence, if at θH is maximized, i.e. a high ability
e∗ (θL ) is observed, then it must be that worker is getting the smallest level of
education that grants him the high type
µ(e∗ (θH )) = 0. Likewise, if e∗ (θH ) is ob- wage w(ẽ) = θH .
served, then it must be that µ(e∗ (θH )) = Therefore an equilibrium with e ∗ (θL ) = 0
1. The resulting wages are respectively
and e ∗ (θL ) = ẽ Pareto Dominates all
θH and θL . others.
Yet, this may be not Pareto Optimum:
e∗ (θL ) = 0 That is,when signalling is not available we are
a wage schedule such that µ(e) = 1 if e ≥ ẽ
back to the Ackerlof Equilibrium, in
that is, a low ability worker chooses and µ(e) = 0 if e ≤ ẽ supports the very
no education. In fact, worker θL always which under a constant r(θ) = r = 0 for
same PBE as before, hence may wage all θ we have seen the wage for those
receives w(e∗ (θL )) = θL in equilibrium, schedules may arise.
regardless of the level of education cho- who work will be E[θ] = λθH + (1 − λ)θL .
sen. Hence, e = 0 is optimal, choosing Now:
Depending on the shape of the cost • Low types are strictly better off at the
e > 0 is not optimal because gets the function, the indifference curves change
b
same wage but now the worker has a and the location of the intersection Ackerlof wage as E[θ] > θL as long as
cost for education. point change as well. In figure be- λ > 0;
we can represents low we represent two other IC along • High types may either be worse off or
a separating equilibrium, with a supporting wage schedule, better off at the Ackerlof wage, this
strictly depends on the fraction of high
types λ in the economy.
The left panel shows that all points that
lie on E[θ] are below the IC of type θH ,
hence yield a lower utility for the high
type and so in this situation there is no
pareto improvement from the Ackerlof
In fi- wage
The right panel shows that λ is high
 Microeconomics to get some education, it may be percei- between [0, e0 ]. marginal cost of t decreases as we
Mattia Albertini, Page 3 di 2 ved as the low type and get a lower wage, However, e∗ = 0 Pareto dominates all increase the type θ.
i.e. there is a wage schedule that has other: it is the only one that is the same Hence just as in the Signalling model,
enough so that there is a set of points beliefs µ(e) so that if a player deviates as in the Ackerlof model. the task level t is used to distinguish
between E[θ] and the IC of type H such from the pooled equilibrium he will be worker’s type;
that the high type can go on a higher IC paid the low type wage. Note that this Equilibrium Refinement: The Cho-Kreps • Utility of worker θ is defined,
and thus is strictly better off with the is simply the equilibrium that would Intuitive Criterion
Ackerlof wage. arise in Ackerlof: there is no education, u(w, t|θ) = w − c(t, θ)
The cause of this pathological situation and the agents end up getting paid the We have seen that in the Spence model of
in which a Pareto Improvement depends highest wage that can be achieved in an signalling multiple equilibria can arise:
on the value of λ is caused by the fact Ackerlof equilibrium. Stages of the Game
that in a separating equilibrium the no Another pooled equilibrium that The game goes as follows,
• Equilibria can be separating or pooled; 1. Nature selects the worker’s type, pri-
signalling outcome (w, e) = (E[θ], 0) is no can arise at level of education e0 is, • Within separating or pooled equilibria
longer available to high ability workers: At vately observed;
we may have many education levels.
if λ is not high enough, a high type that a separating equilibrium, we have alrea- 2. Two firms simultaneously announce
chooses no education when signalling dy argued that player L plays e∗ (θL ) = 0 sets or ä menuöf contracts, i.e. a con-
is available, will be thought to be a low This mostly stems from the fact that and gets θ , the high type can play any tract is a pair (w, t);
firms are unconstrained in choosing L 3. Given the contracts, the worker’s deci-
type and will get θL as wage. ∗
Finally note that for λ → 1 then beliefs off the equilibrium path, i.e. for e (θH ) between ẽ and the intersection de which contract to accept (if any). If
every educational choice, being it the between his IC and the horizontal line a worker is indifferent, we always ass-
E[θ] → θH , and therefore nearly all same or different, there is a set of beliefs from θH . We have also argued that the
workers get education if signal is availa- choice of education of player H at ẽ ume the contract with the lower task.
over all the off equilibrium path that If contracts of two firms are equally
ble, thus the distorsion to the Ackerlof defines a wage schedule that supports Pareto dominates all others: we can also
case is even bigger because in a world prove that all others but ẽ are destroyed In this preferred, we randomize 50 : 50.
that equilibrium. game there is no uncertainty and
with only high types they would be We can put some restrictions on the by the intuitive criterion.
simply offered E[θ] ≈ θH without having To see this, suppose e ∗ (θ ) = e∗ , note therefore no beliefs. The solution con-
off equilibrium path beliefs so that we H cept is the one of Subgame Perfect Nash
to attain any education. can "pruneßome unreasonable Nash that whatever is µ(e), player L will never Equilibrium (SPNE): i.e. in equilibrium
Pooled Equilibrium ∗
Equilibria, i.e. the Cho-Kreps Intuitive play e ∈ [ẽ, e ] as will be on a lower IC. there are no profitable one shot deviati-
A pooled equilibrium arises when the Criterion. To see it in action, consi- Thus by the Intuitive Criterion µ(e) = 1 ons.
two worker types choose the same level der the following pooled equilibrium, for e ∈ [ẽ, e∗ ], but then w∗ (e) will not be as Public Equilibrium
of education, Note that both get paid E[θ] and choose drawn: it will be a horizontal line from If types were observable, two worker ty-
education e0 . A supporting wage schedu- ẽ to e∗ . Hence by choosing e∗ (θH ) = e∗ pes the contract offered are 2, one for
e∗ (θL ) = e∗ (θH ) = e∗ player H is not playing optimally because each worker’s type, (wL , tL ) and (wH , tH ).
le is as follows: at e0 , we have µ(e0 ) = λ
Since firms cannot discriminate between and thus w∗ (e0 ) = E[θ]. is not maximizing utility. This kills all In any SPNE of the screening game with
the two types, on the equilibrium path, It turns out that, there is a continuum of separating equilibrium but the one for observable worker types, a type θi ac-
they a worker comes in at the interview pooled equilibria in e∗ ∈ [0, e0 ]: i.e. sup- which e∗ (θL ) = 0 and e∗ (θH ) = ẽ, which is cepts contract,
with level e∗ it must be that the firm be- pose that L chooses e∗ < e0 , in a pooled the best separating equilibrium there can
lieve the worker to be high type with pro- equilibrium also H chooses e∗ < e0 , thus be (however, it may still be dominated by (wi∗ , ti∗ ) = (θi , 0)
bability µ(e∗ ) = λ, therefore the wage in L and H both are paid E[θ] and have the no signalling or Ackerlof equilibrium
equilibrium equals E[θ], depending on the fraction λ as already and firms earns zero profits.
a lower level of education than on e0 . argued). Proof: Any equilibrium contract (wi∗ , ti∗ )
∗ ∗ Similarly this discussion goes on up to
w (e ) = λθH + (1 − λ)θL = E[θ] e∗ = 0. On the other hand, note that L The pooled equilibrium is at e∗ = 0 for
3 Rotschild/Stiglitz Model of Competiti- must involve zero profits, that is wi∗ = θi
ve Screening
In other words, on the equilibrium path, would never choose e∗ > e0 as in a pooled
both types. It is clear that e ∈ (e1 , e2 ) is Set Up for all i. Otherwise if wi∗ > θi firms make
always the average wage is paid, because equilibrium he would get paid E[θ] but strictly worse for player L, which therefo- Suppose there is no signalling device. To a loss, if wi∗ < θi profits are positive, one
my beliefs, by Bayes rule, must equal the education will be too costly: in other re has no incentive to deviate. Similarly, discover unobservable types firms may firm could deviate and offer w∗ + ε < θi
i
prior (λ). words, any point at the right of the IC player H has no incentive to deviate screen the individual’ types. Consider a
and gain all workers and make profits;
The only issue is what is the educa- of θL lies on lower indifference curves, because firms may have beliefs so that, if model in which:
this continues up to the point wi∗ = θi
tion level chosen by the types. Sup- he chooses an education level e ∈ (e1 , e2 ) • Two CRTS firms; ∗
pose that the two worker types both he may be perceived as a low type, and • Two types θ > θ > 0 with λ = P(θ = and profits are zero. Thus, wi = θi .
H L
choose e∗ = 0: the beliefs equals the this because the firms have no restric-
θH ); Now, suppose that (wi∗ , ti∗ ) =
priors µ(0) = λ, the wage will be E[θ] tions on the beliefs off the equilibrium. (θ , t 0 ) for t 0 > 0 as in figure,
However, the Intuitive Criterion add an • Reservation wage is r(θ L ) = r(θ H ) = 0; i
additional restriction: off the equilibrium • Jobs assign different tasks t ≥ 0 to wor-
path, in the interval e ∈ (e1 , e2 ) it must kers (jobs with higher tasks have no
be µ(e) = 1 (as it is convenient only for intrinsic value);
H to deviate). Note that this destroyes • Task t for agent θ comes at a cost
the pooled equilibrium: H is no longer c(t, θ).
playing optimally at e∗ = 0 because if 1. c(0, θ) = 0;
he deviates to any e ∈ (e1 , e2 ) he will be 2. ct (t, θ) > 0 and ctt (e, θ) > 0: cost is
paid θH , and then the lower type will increasing and convex in task;
be paid θL . So we have destroyed the 3. cθ (t, θ) < 0: the same level of t is
less costly for high types than for
Hence, from a starting education level, pooled equilibrium. low types.
any intersection point can happen over
There is no incentive to deviate from a We can also destroy separating 4. ctθ (t, θ) < 0: Spence-Mirlees sin-
pooled equilibrium: if either one decides the horizontal line that stems from E[θ] equilibria with the same reasoning, gle crossing condition, that is, the From the initial position, a firm could
 Microeconomics
Mattia Albertini, Page 4 di 2
deviate at (w̃, t̃) with w̃ < θi and t̃ < t 0 ,
which is on a higher IC, and earn positive
profits. Only at (wi∗ , ti∗ ) = (θi , 0) there 3. Lemma 3: If (wL , tL ) and (wH , tH ) are
are no profitable deviations, the only
contract that maximizes utility and
allows the firm to break even. QED.
Private Equilibrium
If types are not observables, public
equilibrium is not attainable: eve-
ry worker prefers (θH , 0) to (θL , 0),
so if these are proposed, all would
choose (θH , 0). To determine the equi-
librium draw the break even lines,
where the break even at E[θ] represents
a contract that attracts all types, and so
is called "Pooled break even".
We have separating and pooled equili-
bria, to show equilibrium we proceed
with a series of lemmas:
1. Lemma 1: In any equilibrium, pooling
or separating, both firms must earn ze-
ro profits.
Proof: Suppose (wH , tH ) and (wL , tL )
are offered and chosen by the high and
low types, and suppose aggregate pro-
fits are Π > 0. Each firm makes at most
Π/2. Suppose one firm deviates and
offers (wH + ε, tH ) and (wL + ε, tL ), this
attracts all workers, and for ε small
the profits of the deviating firm are
close to Π. Thus, since there are pro-
fitable deviations as long as Π > 0, in
an SPNE it must be that Π = 0.
2. Lemma 2: No pooling equilibria exits.
Proof: Suppose there is a pooling equi-
librium (wp , t p ). By lemma 1, it lies on
the "Pooled Break even Lineäs below,
One firm may deviate to (w̃, t̃) at-
tracting all type H workers and no
low type and earns positive profits
as w̃ < θH , hence by Lemma 1 there
cannot be a pooled equilibrium. QED.
contracts signed by the low type and
high type in a separating equilibrium,
each contract must yield zero profits,
hence,
wL = θL and wH = θH
Proof: Suppose a contract with
wL < θL is part of equilibrium with
effort tL . Then offering (wL + ε, tL )
attracts (at least) all L workers and
yields positive profits. Then by Lem-
ma 1 there cannot be profitable
deviations, it must be wL ≥ θL .
Suppose workers choose
wH < θH , as in figure below,
5. Lemma 5: In any separating equilibri-
Then, since we proved wL ≥ θL but
also since firms are gaining profits
from wH < θH it must be they are
losing profits from the low types to
compensate, so wL > θL (cross subsi-
dization). Moreover, (wL , tL ) must lie
in the hatched region:
(a) Since type H chooses (wH , tH )
over (wL , tL ), then (wL , tL ) must
lie below the H indifference cur-
ve;
(b) Since L chooses (wL , tL ) over
(wH , tH ), it must lie above the L
indifference curve.
Now, suppose one firm deviates from
(wH , tH ) to (w̃H , t̃H ), this contract at-
tracts all H workers, no L worker, and
grants positive profits as still w̃H <
θH . In fact, the firm that did not devia-
te now employs only L types, making
negative profits, the other firms em-
ployees all H types and some L types,
thus earning strictly positive profits.
Since this cannot happen, we must ha-
ve wH ≥ θH .
By Lemma 1, firms must break even
in any separated equilibrium, hence
we must have wL = θL and wH = θH .
4. Lemma 4: In any separating equilibri-
um, the low-ability workers accept
contract (θL , 0); that is, they receive
the same contract as in the public
equilibrium.
Proof: By Lemma 3, we know
wL = θL in any separating equili-
brium. Suppose low ability choose a
contract (θL , tL0 ) for tL0 > 0 as below,
If a firm deviates to (w̃, t̃) which is
accepted by all L types and earns
positive profits as w̃ < θL , thus by
Lemma 1 it cannot be an equilibrium.
um, the high ability worker accepts
contract (θH , t̂H ) where t̂H satisfies
the indifference condition (is incen-
tive compatible),
θH − c(t̂, θL ) = θL − c(0, θL )
since c(0, θL ) = 0 it can also be rewrit-
ten as,
θH − c(t̂, θL ) = θL
Proof: By Lemma 3 and Lem-
ma 4, we know that (wL , tL ) =
(θL , 0) and that wH = θH ,
Note:
(a) If low types accept (wL , tL ) =
(θL , 0) it must be that tH ≥ t̂. In
fact, given that wH = θH if tH < t̂,
then the resulting contract would
attract all low types.
(b) If tH > t̂, then a firm may devia-
te to (w̃, t̃). This attracts all H, no
L, and grants positive profits as • As in signalling, low types are always
w̃H < θH . worse off with screening than when
Hence it must be that tH = t̂. Note screening is unavailable because they
that at tH = t̂ the low ability workers would have been better at the Ackerlof
would be indifferent between (θL , 0) wage;
• When the equilibrium exists, high ty-
and (θH , t̂) so t̂ must satisfy the indif-
ference condition,
pes are always better off with screening.
In signalling they were better off or
worse off depending on E[θ]. But here,
θH − c(t̂, θL ) = θL
if E[θ] is too high, the equilibrium do
not really exist.
which concludes the proof. QED.
Hence, to summarize The equilibrium: • If the screening equilibrium exists is by
definition constrained pareto efficient:
In any SPNE of the screening game, low- if no firm can earn positive profits by
ability workers accept (θL , 0) and high deviating, neither a planner can.
ability workers accept (θH , t̂H ) where t̂H 4 Monopoly Screening
satisfies, Set Up
The idea is that there is one firm, called
θH − c(t̂H , θL ) = θL − c(0, θL ) principal, that wants to hire a worker, or
agent. The model differs from the pre-
vious ones because of the timing of when
Existence of Equilibrium the asymmetry of information realizes:
The analysis is not comple- the principal offers a contract with ef-
te, in fact we can show that fort level e fully observable. After signing
an equilibrium may not exist. the contract, the agent learns his type θ.
To see this, suppose that two firms Hence at the time of the contract signa-
are offering (θL , 0) and (θH , tH ) with ture there is "hidden informationöf the
tH satisfying the indifference con- agent, that is, he signs the contract or not
dition as in the left panel below, without knowing his type.
The model is charaterized by:
• One risk neutral firm;
• One dimensional and observable effort
e ∈ [0, +∞);
• Profits depends only on effort π(e) s.t.
– π(0) = 0;
– π0 (e) > 0;
– π00 (e) < 0.
• Left Panel: If E[θ] is below the indif- • Two types θH > θL with λ = P(θ = θH )
ference curve of the H type (as on the privately observed after the contract;
left), then there exist no deviation that • Disutility from effort g(e, θ) s.t.
can attract only low types or high ty- 1. g(0, θ) = 0;
pes and makes positive profits. If a con-
2. ge (e, θ) > 0 for e > 0 and ge (e, θ) = 0
tract is offered in the region below θH for e = 0: disutility is increasing;
and above the indifference curve of H,
all workers would accept the pooling 3. gee (e, θ) > 0: disutility is convex in
contract, however, there is no incentive effort;
in doing so as is not profitable because 4. gθ (e, θ) < 0: the same level of e is
is above the break even pooling line; less costly for high types than for
low types.
• Right Panel: If E[θ] is even slightly
5. geθ (e, θ) < 0: Spence-Mirlees sin-
above the IC of the H type, the a con- gle crossing condition, that is, the
tract (w̃, t̃) in the region below E[θ] and marginal cost of e decreases as we
above both IC, will attract all workers increase the type θ.
to that single pooling contract. Since • One risk averse agent with utility,
we have ruled out existence of pooled
equilibria, this means that in this case u(w, e, θ) = v(w − g(e, θ))
no equilibrium exist.
Hence an equilibrium exists if there is no risk aversion comes from v 0 (·) > 0 and
profitable deviation to a pooling contract, v 00 (·) < 0.
which may happen if λ is so high that • Reservation utility or öutside optionöf
E[θ] is above the IC of H. the agent is u
Welfare Properties Stages of the Game
Note that when the equilibrium exists, it The game goes as follows,
has the same welfare properties of the 1. Contract is signed;
least inefficient or best separating equili- 2. Nature selects worker type (H or L),
brium of the signalling model: privately observed;
 Microeconomics g(eL∗ , θL )), so from the participation cons- and hence, chanisms. To see the idea, consider any implies that the problem boils down to,
Mattia Albertini, Page 5 di 2 traint above, eL < e H contract that implements (wH , eH and
(w max λ[π(eH ) − wH ] + (1 − λ)[π(eL ) − wL ]
moreover, from the risk sharing condi-
∗ − g(e∗ , θ )) = v(w∗ − g(e∗ , θ )) = u L , eL ) in states θH and θL . A truth- wi ,ei >0
3. Agent takes effort e at cost g(e, θ); v(wH H H L L L ∗ , θ ) = w − g(e∗ , θ ) this
tion wH − g(eH ful revelation mechanism that genera-
H L L L s.t.
4. Principal earns profit π(e) and pays implies tes the same outcome is as follows: If
wage w. or, the agent announce θL the contract is
∗ > w∗
wH (a) wL − g(eL , θL ) = v −1 (u)
Note that the contract do not specify a L [w(π(eL )), eL ], if the agent announce θH
∗ ∗ ∗ ∗ −1
particular effort and wage, rather speci- wH − g(eH , θH ) = wL − g(eL , θL ) = v (u) We can thus depict both optimal the contract is [w(π(eH )), eH ]. Consider (b) wH − g(eH , θH ) = wL − g(eL , θH )
fies the wage contingent on each realiza- contracts in the same graph as, the incentive in telling the truth: suppose
tion of the effort, which depend on the the agent gets his reservation utility in the state θL is announced, then he will Setting up the lagrangian with multi-
type. To clarify ideas, see the first best. every state. get [w(π(eL )), eL ], i.e. the agent chooses pliers γ for the IR and φ for the IC yields,
Note now that if we plug ei = 0 for ∗
Public Equilibrium eL . If he had announced θH he would ha- wH : −λ + φ = 0
Suppose that θ is publicly observable, i = H, L in both the remaining conditions, ve gotten [w(π(eH )), eH ]. Clearly, since in
state θL agent chooses eL it must be that, wL : −(1 − λ) + γ − φ = 0
though the timing is still äfter"the con- since g(0, θ) = 0 and π0 (0) > 0 in both
tract. A contract here directly specifies conditions we would obtain, eH : λπ0 (eH ) − φge (eH , θH ) = 0
the effort level and remuneration con- w(π(eL ))−g(eL , θL ) ≥ w(π(eH ))−g(eH , θL ) eL : (1 − λ)π0 (eL ) − γge (eL , θL ) + φge (eL , θH ) = 0
tingent on each realization of θ, hence λπ0 (0) ≤ 0 and (1 − λ)π0 (0) ≤ 0
a complete information contract consist thus is optimal to announce the truth.
of two pairs, a clear contradiction, hence both must be The same argument applies if the state is The first two conditions imply that λ = φ
satisfied with equality. Thus combining θH for which, and γ = 1, hence the last two conditions
(wL , eL ) and (wH , eH ) the 1 and the 3, and the 2 and the 4 we
obtain, imply,
these pairs are chosen so to maximize w(π(eH ))−g(eH , θH ) ≥ w(π(eL ))−g(eL , θH )
π0 (eH ) = ge (eH , θH )
expected profits subject to the participa- π0 (eL∗ ) = ge (eL∗ , θL )
tion constraint, To sum up: When state θ is observable, Hence the revelation mechanism implies and,
π0 (eH
∗ ) = g (e∗ , θ )
e H H truthful announcements.
max λ(π(eH ) − wH ) + (1 − λ)(π(eL ) − wL ) the effort ei∗ in state θI is such that π0 (eL ) = ge (eL , θL ) −
λ
[g (e , θ ) − ge (eL , θL )]
{wi ,ei >0} hence the optimal level of effort e∗ in π0 (ei∗ ) = ge (ei∗ , θi ) and fully insures the Now, we can characterize the problem 1−λ e L H
s.t. state θ equalizes the marginal benefits agent, that is, offers w∗ at θ such that to solve in the private equilibrium. We Hence we draw two main conclusions,
i i consider an infinitely risk averse agent, ∗ ,
λv(wH − g(eH , θH )) + (1 − λ)v(wL − g(eL , θL )) ≥ u of effort (in terms of profits) with the v(w∗ − g(e∗ , θi )) = u. • From the first equation we see eH = eH
marginal disutility cost. i i i.e. the expected utility of the manager that is, the high type effort level in the
∗ ∗
The participation constraints make sure The optimal pair (wi , ei ) that satisfies Private Equilibrium equals the lowest utility level across private equilibrium satisfies the same
that on average, the agent has a reason to these conditions is represented below: Note that the public equilibrium out- states. This implies that participation condition as in the public equilibrium,
participate. Note that e ≥ 0 always, there- come is no longer attainable when constraints (IR) must give at least u to therefore first best is attainable in state
fore we do not need any non negativity types θ are privately observed as the the agent in each state, or θH ;
constraint. contract scheme is no longer incentive • From the second equation we see that
Now, we first argue that the participation compatible: In state θH , that is the high eL ≤ eL∗ :
type agent, prefers contract (wL∗ , eL∗ ) to wL − g(eL , θL ) ≥ v −1 (u)
constraint or individual rationality (IR) ∗ ∗ – If λ → 0, no distortion so that
is binding: if it does not, the principal (wH , eH ) as it is evident from the pre- wH − g(eH , θH ) ≥ v −1 (u) π0 (eL ) = ge (eL , θL ) is the same con-
could lower the wages wH and wL and vious picture, in fact it lies on a higher dition as in the public equilibrium,
still have the agent accepting. indifference curve. Thus θH will lie to Along with the IR constraints we requi- hence eL = eL∗ .
Taking the lagrangian and the first order the principal, saying that is actually θL . – If λ → 1 then the distortion is big,
conditions, Note also that this implies a lower profit re incentive compatibility (IC) or truth
of the principal. telling constraints, and with ge (eL , θH ) < ge (eL , θL ) the
− λ + γλv 0 (wH ∗ − g(e∗ , θ )) = 0 left hand side is higher than in
H H the public equilibrium, hence since
To delineate the set of implementa- wL − g(eL , θL ) ≥ wH − g(eH , θL )
− (1 − λ) + γ(1 − λ)v 0 (wL∗ − g(eL∗ , θL )) = 0 The principal (owner) utility increases ble contracts we appeal to the revelation π00 (e) < 0 then eL < eL∗ .
southeast, the agent (manager) increases principle. wH − g(eH , θH ) ≥ wL − g(eL , θH )
Hence note that eL falls with λ. The
(
λπ0 (eH ∗ ) − γλv 0 (w∗ − g(e∗ , θ ))g (e∗ , θ ) ≤ 0
H H H e H H = 0 northwest. Because, in state θi the agent Revelation Principle: Denote the set of idea is that as the probability of high
always receives u, the principal seeks Hence, the problem can be described as type rises, the principal sacrifices pro-
≤ 0 the most profitable point given the
possible states by Θ. In searching for an follows,
ductive efficiency in the low state, in

(1 − λ)π0 (eL∗ ) − γ(1 − λ)v 0 (wL∗ − g(eL∗ , θL ))ge (eL∗ , θL ) optimal contract, the owner can, without
= 0 agent state θi , i.e. the point of tangency order to reduce the rend that is given
between the indifference curve and the loss, restrict himself to contracts of the max λ[π(eH ) − wH ] + (1 − λ)[π(eL ) − wL ] to the agent in the high state.
where the last two condition represents isoprofit curves. The profits of the prin- following form, wi ,ei >0 Now, we need to check that our educated
ßlackness": if e > 0 hold with equality, cipal are Π∗ = π(e∗ ) − v −1 (u) − g(e∗ , θ ), 1. After state θ is realized, the agent is guess was correct, in particular we check
otherwise are inequalities. i i i required to announce which state oc- s.t.
curred; that (i) and (iii) are indeed binding, and
Combining the first two equations we ob- i.e. the vertical distance between the
(i) wL − g(eL , θL ) ≥ v −1 (u)
(
tain, isoprofit passing through (wi∗ , ei∗ ) and the 2. The contract specifies an outcome −1
that (ii) and (iv) are satisfied (because we
origin. [w(θ̂), e(θ̂)] for each possible announ- ((ii) wH − g(eH , θH ) ≥ v (u) ignored them):
v 0 (wH∗ − g(e∗ , θ )) = v 0 (w∗ − g(e∗ , θ ))
H H L L L One last remark: note that since cement θ̂ ∈ Θ; (iii) wH − g(eH , θH ) ≥ wL − g(eL , θH )
• (i) & (iii) → Since φ = λ > 0 and γ =
geθ (e, θ) < 0 and π00 (e) < 0 then, eit- 3. In every state θ ∈ Θ the agent finds 1 > 0 then by complementary slack-
(iv) wL − g(eL , θL ) ≥ wH − g(eH , θL ) ness the constraints are indeed bin-
which implies that the marginal utility her ge (eL , θL ) > ge (eH , θH ) if eL < eH or optimal to report the state truthfully.
of the agent is the same in every state, so ge (eL , θL ) < ge (eH , θH ) if eL > eH . Since Conditions 1 and 2 are known as reve- ding, hence in equilibrium:
that the agent is fully insured. This also gee (e, θ) > 0 though, lation mechanisms, with condition 3 we To solve this problem we take an
implies wH ∗ − g(e∗ , θ ) = w∗ − g(e∗ , θ )
H L say that the contracts offered are incenti- educated guess: we assume that only wL − g(eL , θL ) = v −1 (u)
H L L
and thus that v(w∗ − g(e∗ , θH )) = v(w∗ − ge (eL , θL ) > ge (eH , θH ) ⇒ π0 (eL ) > π0 (eH ) ve compatible (truthful) revelation me- constraints (i) and (iii) are binding, this wH − g(eH , θH ) = wL − g(eL , θH )
 Microeconomics the tangency point will be on a lower • Risk adverse agent with utility, Hence, given the contract specificati- That is,
Mattia Albertini, Page 6 di 2 isoprofit curve. On the other hand, on of e, the owner offers a constant Z
we see that a reduction in eL < eL∗ u(w, e) = v(w) − g(e) wage we∗ such that at that effort level, πf (π|e)dπ − α − g(e)
implies a relaxing of the high type ∗
• (ii) → Since gθ < 0 then by (i) and (iii) IC which allows to offer a lower wage, is risk averse as uw > 0 and uww ≤ 0 at v(we ) − g(e) = u
we have, all (w, e). This implies that, Setting α = u proves that the problem
0 00 that is that the agent solves will yield the first
– v (w) > 0 and v (w) ≤ 0: i.e. positi- best. The idea is that if the agent is risk
wL − g(eL , θH ) > wL − g(eL , θL ) = v −1 (u) ve marginal benefit of higher wage neutral, the problem of risk sharing
with decreasing returns; we∗ = v −1 (u + g(e)) disappears.
thus, since by IC wL −g(eL , θH ) = wH − 0
– g (e) > 0 or g(eH ) > g(eL ): i.e. the cost • Risk Averse: When the agent is risk
g(eH , θH ) constraint wH − g(eH , θH ) > in terms of utils increases with ef- Note also that since g(eH ) > g(eL ), averse, the incentive to exert high ef-
v −1 (u) is satisfied with strict inequali- fort. then we∗H > we∗L . Note that if the agent fort can be provided at the cost of ex-
ty; • Reservation utility of the agent is fixed was risk neutral, then v(w(π)) = w(π) posing the agent to risk. Let’s consider
• (iv) → Since eL < eL∗ < eH = eH ∗ and sin- u. again the two steps problem: consider
and v 0 (w(π)) = 1 so any function w(π)
Public Equilibrium the Cost Minimization: the efficient
ce geθ < 0 then combining the two IC such that w(π) = u + g(e) holds is opti-
constraints yields, Suppose that effort e is observable, the mal. wage w(π) problem now is found by
contract will specify agent’s effort e and 2. Profit Maximization: The optimal minimizing costs over a participation
g(eH , θH )−g(eL , θH ) < g(eH , θL )−g(eL , θL ) wage as a function of profits w(π). In this choice of e that maximizes revenues gi- constraint but also an incentive cons-
case the principal maximizes expected traint, so that the agent desires to choo-
ven the minimized cost (wage). Thus, se effort e,
using that wH − g(eH , θH ) = wL − profits over all possible values of π which
depend on e, subject to a participation Z
g(eL , θH ) yields, Z π
constraint u(w(π), e) ≥ u, max −1
πf (π|e)dπ − v (u + g(e)) min w(π)f (π|e)dπ
e∈{eL ,eH } π w(π)
wH − g(eH , θL ) < wL − g(eL , θL ) Zπ
s.t.
thus constraint (iv) is satisfied. max (π − w(π))f (π|e)dπ hence eH or eL is chosen depending Z
e∈{eL ,eH },w(π) π
Hence, indeed we can solve the maxi- ∗ ∗ on the the incremental increase in ex- v(w(π))f (π|e)dπ − g(e) ≥ u
mization problem with two binding moving from (ŵH , eH ) to (w̃H , eH ) with Zπ pected profits compared with the mo-
constraints, (i) and (iii) ignoring (ii) ŵH > w̃H , which implies a profit gain in s.t. v(w(π))f (π|e)dπ − g(e) ≥ u netary costs of the incremental disuti- Z
and (iv). this yields to the following state θ H . π lity from eH to eL . e = arg max v(w(π))f (π|ẽ)dπ − g(ẽ)
5 Hidden Actions/ Moral Hazard First Best: When effort is observable, the ẽ
conclusion:
In the private equilibrium the optimal The idea is that a firm, called principal The objective function can be written as, optimal contact specifies that the mana- The second constraint is the incenti-
ger choose the effort e∗ that maximizes
contract sets effort in state θH equal wants to hire a worker, the agent and the π
ve constraint: insures that under sche-
∗ . The effort in state profits of the firm depend on effort taken π π
R
Z Z
πf (π|e)dπ − v −1 (u + g(e)) and pays fi- me w(π) the optimal chosen effort is e.
to the first best eH by the agent, which is unobservable after π
πf (π|e)dπ − w(π)f (π|e)dπ Now consider two cases,
θL is distorted downward from its first the contract. Contracts must be designed π π xed wage w∗ = v −1 (u +g(e∗ )). This contact 1. Implement eL : If the principal wants
∗
best level eL . In addition, the agent in such a way that the agent is induced specifies the efficient effort and fully in- to implement eL , simply offer the
in inefficiently insured, receiving a to engage in the optimal level of effort. Which makes clear that the profit maxi- sures the agent. agent the fixed wage
utility greater than u in state θH and Note that the there is no uncertainty on mization can be done in two stages: Private Equilibrium
equal to u in state θL . The principal the types: the uncertainty is on the effort 1. Minimize costs: optimal w(π) for When effort level is not observable full we∗ = v −1 (u + g(eL ))
expected payoff is strictly lower than taken. More specifically, each e, insurance is in conflict with the optimal
in the public equilibrium, while the • Risk neutral principal; that is the wage offered if eL is ob-
effort, in fact the willingness to exert the servable. In fact, no matter what the
expected utility of the agent is the same • One dimensional and unobservable ef- Z π right amount of effort a priori depends
as in the public equilibrium. Graphically, fort e ∈ E ⊂ R; min w(π)f (π|e)dπ agent chooses, the worst is always
• Profits π(e) depend on effort, however on profits that are now random (realized eL , thus simply offer the minimum
w(π) π
there must not be a deterministic relati- only after the contract is signed). To dis- fixed wage: i.e. the incentive cons-
Zπ cuss this case, we study both the case of a
on otherwise the principal can deduce traint do not bind.
the effort e by looking at the profits. s.t. v(w(π))f (π|e)dπ − g(e) ≥ u risk neutral agent, and risk averse agent: 2. Implement eH : If the principal
π • Risk Neutral: If v(w) = w, if effort was wants to implement eH , we need to
For this, assume π is distributed over
[π, π] and is stochastically related to e observable we would have achieved the solve the optimization. With only
via a density function f (π|e) > 0 for all which yields the optimal wage w∗ (π) first best effort as, two effort levels, we can rewrite the
at all e (indirectly, via π). Setting incentive constraint as,
e ∈ E and π ∈ [π, π]; Z
• Two effort choices eH > eL . We have up the Lagrangian with multiplier γ ∗ Z
and taking the FOC for a fixed e gi- e = max πf (π|e)dπ − g(e) − u
that the cdf of profits, e∈{eL ,eH } v(w(π))f (π|eH )dπ − g(eH ) ≥
ven a binding participation constraint
(otherwise wages could be lowered),
Z
F(π|eH ) ≤ F(π|eL ) at all π ∈ [π, π] If effort is not observable and the agent v(w(π))f (π|eL )dπ − g(eL )
0 ∗
is risk neutral the first best effort can
that is, profits are everywhere higher −f (π|e) + γv (w (π))f (π|e) = 0 be still achieved. Suppose the princi-
under eH with respect to eL . Hence, al- pal offers w(π) = π − α where α is some Set the lagragian with γ and µ re-
so expected profits are larger under eH thus, constant (ägent selling the project to spectively multipliers on participa-
The figure shows the loss in the owners than under eL , 1 principal"with α the fixed price), then tion and incentive, the FOC imply
0 ∗ =γ that
profits that derives from the inefficient Z Z v (w (π)) the agent chooses e so to maximize his
∗
choice eL < eL : if from the efficient expected utility, 1
"
f (π|eL )
#
πf (π|e H )dπ > πf (π|e L )dπ which implies that with a risk aver- = γ +µ 1−
contract (wL∗ , eL∗ ) we lower down to se agent, v 00 ≤ 0, w∗ (π) = we∗ must be Z v 0 (w(π)) f (π|eH )
∗
(w , eL ) along the IC of θL we see that independent from π, i.e. a constant. w(π)f (π|e)dπ − g(e)
 Microeconomics
Mattia Albertini, Page 7 di 2

In any solution γ > 0 and µ > 0. To see

this note that for γ = 0 then the wage
could converge to zero without upsetting
the incentives. If µ = 0 then the agent
would always choose eL .
This expression holds for all π and is non
trivial: note that on the right hand side
we have two constants γ and µ along with
the likelihood ratio. Note that if µ = 0 or
the term in squared brackets was 0 then
we would recover,

1
=γ
v 0 (ŵ)

which is the condition for the first best

wage ŵ. However,


f (π|e )
w(π) > ŵ


 if f (π|e L ) < 1
H
 f (π|e )
w(π) < ŵ if f (π|e L ) > 1


H

Hence, the wage is higher than first

best if high realizations of π occur un-
der eH and viceversa. The key point
is that at the optimum, compensation
is not necessarily monotonically in-
creasing in profits, it really depends
on the likelihood ratio. Moreover, it
implies that the optimal contract is not
likely to take a simple linear form, i.e.

In conclusion, the wage schedule of this

problem is very complicated. Moreo-
ver, the problem can get much more
complicated for more than two effort
levels: if we were to allow for more than
two effort levels, i.e. three, I should
use two incentive constraints, if I have
a continuum i would have an infinite
number of constraints (and multipliers!).
Moreover, Mirlees has proven that this
first order condition is neither sufficient
nor necessary to find an optimum. Hence
the solution to this problem remains
unsolved.