Information Economics

Problem Set 1

1. An entrepreneur has a project that yields revenue R with probability and 0 with
probability (1 ). A debt contract speci…es a reimbursement t to the lender if the
project is successful, and an amount of collateral C 0 to be paid to the lender if the
project fails. The value of the collateral is C for the lender, where 0 < 1. The
project involves a …xed nonmonetary cost b for the entrepreneur (the opportunity cost
of his time). The entrepreneur’s expected utility (call it u1 ) is 0 if he does not borrow
(the project is not realized) and (R t) (1 )C b if he borrows. The amount
borrowed is …xed and is equal to 1. Assume R > b + 1 for any . The lender’s utility
(call it u0 ) is t + (1 ) C 1 if he lends, and 0 otherwise. The entrepreneur has
private information about , which takes value with probability p and value with
probability p (with p + p = 1 and < ).

(a) Suppose that there is a monopolist lender who o¤ers a debt contract to the entrepreneur.
Show that if the lender knew he would not require any collateral.

(b) Suppose that the monopolist lender does not know . What are the binding individual
rational (IR) and incentive compatible (IC) constraints? Assuming that the creditor
wants to lend whatever , show that the lender o¤ers the pooling contract ft = R
b= ; C = 0g. Explain intuitively the di¤erence with the discrimination case, analyzed
in the previous point.

(c) Suppose now that there is a competitive credit market (many lenders). Argue that the
relevant IC constraint is not the same as in the previous point. Show that, if a zero-
pro…t, separating equilibrium exists, the levels of collateral for types and are C = 0
and C = (1 ) (1 ) , respectively. (Assuming that the entrepreneur’s initial wealth
is at least C; otherwise credit rationing may occur).

2. A monopolist faces three types of customers, that is the set of types is = f1; 2; 3g.
Each type is willing to pay v( ; q) = q for an item of quality q. The cost of a
unity of quality q is C(q) = 12 q 2 . The proportion of type is f . Call p the price
the monopolist charges for each unit sold to type . Assume there is no possibility of
resale between the buyers.

(a) Assume full information. What would be the pro…t maximizing quality levels and what
prices would the monopolist charge?

(b) Assume the type is private information. State the problem of the principal and explain
which constraints must be binding.

(c) Compute the surplus (information rent) for each type of buyer.

(d) Obtain an expression of the total pro…t of the monopolist. What would happen if f3 is
very large? The quality levels o¤ered by the monopolist would be reduced? Explain.