Chapter 4

Asymmetric Information Models

Carmen Arguedas
Catedrática de Fundamentos del Análisis Económico
Dpto. Análisis Económico: Teoría Económica e Historia Económica

Room: 10-310
E-mail: carmen.arguedas@uam.es
Website: https://sites.google.com/site/carmenarguedasuam/
Twitter: @CarmenArguedasT
OUTLINE

1. The principal – agent model

2. Moral hazard problems
3. Adverse selection problems

MAIN REFERENCE: Book by I. Macho-Stadler and D. Perez-Castrillo

1. The principal - agent model

The Economics of Information studies the behavior of economic agents in

situations of asymmetric information.

These are situations where either consumers, producers, sellers, the

Government, insurance companies, or banks… are better informed about
a particular aspect of the economic situation than the remaining agents with
whom they stablish an economic relationship.

The Economics of Information studies the economic consequences of

such asymmetries: In particular, the strategies of the economic agents and the
degree of efficiency of the economic relations and/ or contracts signed.
 THE STARTING POINT:

Agents with private information have an advantage with

respect to the remaining agents in the economic relationship

Private information distorts contracts because informed individuals

will try to benefit themselves from the informational advantage
 All the individuals in the relationship
THE BASE MODEL
own the same information
(symmetric information)

PRINCIPAL She designs a contract (or set of contracts) to be offered to the agent

AGENT He accepts the contract if he so desires

NATURE There are some ramdom effects

A has to carry out some sort of task (effort e) in exchange for a payment (wage w)

The relationship allows a certain outcome to be obtained (with monetary value x)

The final outcome depends on the effort supplied by A and on random factors
P designs A accepts A supplies N determines Outcomes and
the contract (or rejects) effort state of the world payoffs

QUESTION: WHAT IS THE OPTIMAL CONTRACT?

SOLUTION CONCEPT: SUBGAME PERFECT EQUILIBRIUM

NOTATION

X = {x1, x2, …, xn} Set of possible outcomes, such that x1 < x2 < … < xn

e: effort level supplied by the agent e Є { eH, eL}, eH > eL, c(eH) > c(eL)

Prob [x = xi / eH] = pi H > 0 Prob [x = xi / eL] = pi L > 0

p1 H + p2 H + … + pk H < p 1L + p 2L + … + pk L, when k < n −1

w: wage paid by the principal to the agent

x – w: net payoff of the principal (risk neutral)

U (w,e) = u(w) – c(e) Utility function of the agent (u’ > 0, u’’ ≤ 0, c’ > 0, c’’ ≥ 0)
(risk averse)
P is interested in x (A not so)
CONFLICT OF INTERESTS!!
A is interested in e (P not directly so)
Greater e makes better x more likely
OPTIMAL CONTRACT

Max Σ pi (e) (xi – wi)

Principal’s
[e, (wi)i=1, 2, …n] objective function

s.t. Σ pi (e) u(wi) – c(e) ≥ U Agent’s participation

constraint

The optimal contract especifies the effort level,e, and wages contingent
on the results, wi. The effort level is verifiable.
THE OPTIMAL PAYMENTS MECHANISM

𝑢 𝑤 𝑢 𝑤 , for all i and j. (Pay a fixed salary 𝑤 ,

independent of the outcome)

Σ pi (e) u(wi) – c(e) = U (The participation constraint is binding: the

principal has no reason to pay more than
strictly needed to induce agent’s acceptance)
 THE OPTIMAL CONTRACT

Max Σ pi (e)xi – 𝑤

[e, 𝑤

s.t. u(𝑤) – c(e) ≥ U

Calculate expected profits under the optimal payments mechanism

for each effort level, and select the option resulting in larger expected profits
2. Moral hazard problems

Now, effort cannot be verified by the principal

There are two implications:

1) There is an efficiency loss since the agent’s decision

cannot be controlled by the principal

2) The optimal contract balances efficiency and agents’

incentives
EXAMPLES OF “MORAL HAZARD” PROBLEMS
During a contractual relationship

INSURANCE MARKETS
Insurance companies
may not perfectly verify
the level of care / precaution
of the insured individuals
SERVICES (AFTER PURCHASE)
Doctor/patient relationships
Producer/ distributor relationships
Consumer/seller relationships

LABOR MARKETS LOANS/ MORTGAGES

Employers Banks
may not perfectly verify may not perfectly verify
the level of effort how clients
of the employees spend their money
(tele-work)
In Public regulations / Public policies

MONITORING AND ENFORCEMENT

(Tax evasion,
non-compliance of environmental norms,
violation of safety regulations,
crime …)

Public authorities may not know the behavior

of the agents with respect to public norms
How do we solve the moral hazard problem?

The contract must give the necessary incentives to the agent

to supply the effort level desired by the principal

Effort is not observable, but the results (xi) are observable.

Then, results (profits, sales, market share, or others ) will be
used to specify the payments to the agent (salary)

KEY: ALLIGN INCENTIVES

P designs A accepts A supplies N determines Outcomes and
the contract (or rejects) non-verifiable state of the world payoffs
effort

QUESTION: WHAT IS THE OPTIMAL CONTRACT?

SOLUTION CONCEPT: SUBGAME PERFECT EQUILIBRIUM

Just to understand the nature of the problem…

Consider the optimal contract under symmetric information: The optimal salary is
fixed, w*, independent of the result.

But if effort is not verifiable, once the agent has signed the contract he will
exert the effort level most benefitial for himself. Since the salary does not
depend on effort, he will exert minimum effort. This will result in an efficiency
loss from the principal’s point of view.

With a contract based on a fixed wage, the principal should be able to

anticipate this reaction. Thus, the wage should exactly compensate the agent
for the effort he supplies. Thus, wmin should be such that:

u (wmin) – c (emin) = U Hence, if the principal wants to induce 𝑒 ,

she should pay the minimum salary associated
with accepting to work in exchange for 𝑒
The problem becomes interesting if the principal wants to induce high effort.

We need to search for a contract under which the agent’s pay-off depends
on the final result achieved (otherwise, the agent will just exert low effort)
We need the following condition on the salary scheme:

∑ piH u (wi) − c(eH) ≥ ∑ piL u (wi) − c(eL)

Or put differently: Incentive

compatibility

∑ (piH − piL ) u(wi) ≥ c(eH) − c(eL) Constraint (IC)

The agent chooses effort eH if the expected utility gain associated with
high effort is greater than the increased disutility (or cost)
The optimization problem is the following:

Max Σ piH (xi – wi)

{wi}i=1, 2, …n

s.t. ∑ piH u (wi) − c(eH) ≥ U (PC)

∑ (piH − piL ) u(wi) ≥ c(eH) − c(eL) (IC)

…And the solution is 𝑤 , 𝑤 , … , 𝑤 such that:

∑ piH (u (wi) − c(eH) = U

∑ (piH − piL ) (u(wi) = c(eH) − c(eL)

Some applications:

• Incentives for managers (labor markets)

• Banking (credit markets)

• Insurance theory

• Environmental and natural resource problems

3. Adverse selection problems
Adverse selection might occur previous to the existence of a contractual
relationship between economic agents. In such contexts, one or several agents
might have an informational advantage with respect to other agents.

This problem might cause that a contractual relationship that would be

mutually benefitial for the individuals is not signed.

For example, some consumers might decide not to purchase certain products or
services due to consumers’ lack of information regarding the quality of such goods
or services (while if quality were known, consumers would be willing to pay
more than the price announced by the seller)

Also, doubting about the seriousness of a business (such as those in the Internet)
might result in lower sales than those under complete information.
EXAMPLES OF ADVERSE SELECTION PROBLEMS

Before signing a contractual relation

PURCHASING DECISIONS
INSURANCE MARKETS
Potential buyers of products/services
Insurance companies
may not know
may not know
all the characteristics
all the characteristics
of the products/services
of the potential clients
and /or those of the seller
(housing, used cars,
purchases in the Internet,...)

LABOR MARKETS
Employers BANKS
may not know Banks may not know
all the characteristics all the characteristics
of the potential employees of the potential clients
(for loans, mortgages,…)
In Public regulation / Public policy

DESIGN OF PUBLIC NORMS

(environmental regulation,
safety, health, taxes...)
Public authorities
may not know all the characteristics
of the regulated individuals
How can adverse selection problems be solved?

SIGNALING

The more informed party signals his characteristics to the less

informed party

Warranties
Publicity
Education…

SCREENING

The less informed party designs a set of alternatives from which the
Informed parties can select.
Example (market for second-hand cars) Akerlof (AER, 1970)

100 sellers of a used car (all cars are of the same brand)
100 potential buyers

Two quality types: high quality (H) and low quality (L)

8400 euro, if quality H

Minimum selling price
(WTA) 5000 euro, if quality L

Maximum willingness to pay 9000 euro, if quality H

(WTP)
6000 euro, if quality L
Information structure
Sellers only know the quality of the car they sell (they do not know
the quality of the other cars sold by other sellers) . Potential buyers
cannot appreciate the quality level of any car, prior to purchase.
Both buyers and sellers know there is a probability that a car is of
quality H, given by s, 0 < s < 1.
 The purchasing decision is risky: buyers do not know the exact quality
of the car they are buying.

Under risk neutrality, the maximum a buyer would be willing to pay for a car
(assuming that H occurs with probability s) is the following:

s (9000) + (1-s) (6000) = 6000 + 3000s

If s = 0,5, then the maximum pice the buyer would pay is 7500 euro

Thus, high quality cars are not sold (expected WTP is below WTA),
and only low quality cars would be sold.

ADVERSE SELECTION PROBLEM: high quality cars are not sold

even when there are consumers that are willing to buy a high quality car
If they knew for sure that the car is of a high quality
What is the minimum level of s such that the adverse selection problem
disappears?

We need:

s (9000) + (1-s) (6000) ≥ 8400

This holds when s ≥ 0,8 (intuitively, the estimation of the probability of

high quality must be sufficiently large)

The presence of risk aversion augments the adverse selection problem

NOTATION

Risk neutral principal: π(e) – w (with π’ > 0, π’’ < 0)

Two types of agents which differ with respect to the disutility of effort

UG (w,e) = u(w) – c(e) Utility function of the good type

UB (w,e) = u(w) – k c(e) Utility function of the bad type

q: probability of an agent being type G

N chooses P designs A accepts A supplies N plays Outcomes and

the type of A the contract (or rejects) verifiable effort payoffs
COMPLETE INFORMATION

Max π(e) – w
[e, w] k = 1 if contracting with the good type
k > 1 if contracting with the bad type
s.t. u(w) – k c(e) ≥ U

The solution is 𝑒 , 𝑤 for every 𝑘.

If 𝑒 is observable, then the contract can be enforced.

However, if 𝑒 is not observable, we should be sure that the incentive

compatibility constraints are satisfied:

For 𝑘 1: 𝑢 𝑤 𝑐 𝑒 𝑢 𝑤 𝑐 𝑒

For 𝑘 1: 𝑢 𝑤 𝑘𝑐 𝑒 𝑢 𝑤 𝑘𝑐 𝑒

Generally, one of the IC conditions will not be satisfied (unfortunately,

the one related to the good type)
ASYMMETRIC INFORMATION Screening

Max q[π(eG)-wG] + (1-q) [π(eB)-wB]

[eG, eB, wG, wB]

s.t. u (wG) – c(eG) ≥ U Agents’ participation

constraints
u (wB) – k c(eB) ≥ U

u (wG) – c(eG) ≥ u (wB) – c(eB) Agents’ incentive

compatibility
u (wB) – k c(eB) ≥ u (wG) – k c(eG) constraints
 Characteristics of the optimal solution

1. Both effort levels are lower than under complete information

2. eG > eB
3. wG is larger than under complete information
4. wB is lower than under complete information
5. wG > wB.
6. The good types receive informational rents (they are compensated more
than the reservation utility) and they are indifferent between the two contracts
7. The bad types do not receive informational rents (they are compensated to
exactly cover their reservation utility level) but they strictly prefer the contract
intended for their type.
8. The properties of the solution remain the same under risk aversion
 Signalling
Example: GUARANTEES AS A QUALITY SIGNAL

(second hand cars example continued…)

Suppose there are H and L quality cars, but potential buyers do not know
the quality of any particular vehicle a priori.

Sellers can offer a guarantee against the possibility of break-down. Assume

the guarantee costs 200 euro per year to a seller of a H type car,
while it costs 2000 euro per year if the seller owns a L type car.

Would a seller of a H type car be willing to offer a guarantee to signal

he/she sells high quality? If the answer is YES, how many years should
the guarantee last?
Summarizing...

Offer sufficiently extended guarantee can be a signal of quality H.

Otherwise, the potential buyer might think the seller is not sure about the
quality of the vehicle he is selling.
A poor guarantee could signal low quality.

However...

In many cases, partial guarantees are offered to avoid moral hazard.

THE SOLUTION: Find the appropriate balance between the

cost savings for a more restrictive guarantee (pursuing agents to be
more careful) and the additional expenses for offering a better guarantee
that signals high quality
LABOR MARKET WITH ASYMMETRIC INFORMATION REGARDING
WORKERS PRODUCTIVITY

Assume there are four types of workers and an equal (and large) number
of workers of each type. Workers’ productivities are the following:

Worker type If hired Outside option

1 56 40

2 43 30

3 28 20

4 13 10

Is there adverse selection if the employer does not know the productivity of each
potential candidate?
The solution: EDUCATION AS A PRODUCTIVITY SIGNAL

Under what conditions the education level (measured in years studying,

academic degrees...) can work as a productivity signal?

Assumptions:

1) Many firms produce the same good with a constant returns to

scale technology that uses labor as input (highly competitive sector)

2) There are many workers of two possible types: high productivity

(a2) or low productivity (a1), such that a2 > a1. Only the worker knows his
own productivity. The firm only knows that there is a proportion s
of high productivity workers.
Education does not affect productivity Spence’s model

If firms could observe the productivity level, they would pay salary =
productivity (a1 if low productivity and a2 if high productivity)

If firms cannot distinguish productivity, they will pay salary = average

productivity:

w = s a2 + (1-s) a1

If ALL workers are willing to work at this salary (that is, there is no adverse
selection problem), all the firms will produce the same amount of the product
and obtain the same benefits as if there were perfect information
about workers productivity (POOLING EQUILIBRIUM )

If high productivity workers are not willing to accept w (we have

adverse selection), these workers might be interested in signalling
their productivity
Assume workers can invest in education (e) to signal productivity. Asume
education does not affect productivity.The cost of education (per year) is c2 for
high productivity workers and c1 for low productivity workers, such that c2 < c1.

Under what conditions would the good workers signal their productivity by
means of the education level?

Education investment must be worth only for high productivity workers.

The following conditions are needed:

1) For high productivity workers, the cost of education (c2 e)
must be smaller than the additional increase in salary (a2 –a1)

2) For low productivity workers, the cost of education (c1 e)

must be higher than the additional increase in salary (a2 –a1)

Therefore, the education level should be such that:

(a2 – a1) / c1 < e* < (a2 – a1) / c2

Thus, a situation where high productivity workers invest e* in
education and receive a salary a2 ,and low productivity workers do not
invest in education and receive a salary a1 is a SEPARATING EQUILIBRIUM.

Why?

1) Each worker is paid his productivity

2) Low productivity workers find obtaining education very expensive

3) Education investment is worth for high productivity workers only,

since they can signal their productivity and can receive a larger salary