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Exercise 11.

Principles and Analysis Frank Cowell

March 2007

Ex 11.3(1): Question

purpose: solution to an adverse selection problem method: find full-information solution from reservation utility levels. Then introduce incentive-compatibility constraint in order to find second-best solution

Ex 11.3(1): participation constraint

The principal knows the agents type So maximises x y subject to

where u = 0 for each individual type

In the full-information solution

the participation constraint binds there is no distortion

Ex 11.3(1): full-information case

Differentiate the binding participation constraint
to find the slope of the IC:

Since there is no distortion this slope must equal 1 This implies Using the fact that u = u and substituting into the participation constraint:

Ex 11.3(1): Full-information contracts

ub _ y
Space of (legal services, payment) a-types reservation utility b-types reservation utility Contracts

y*a = 1

slope = 1

ua _

y*b =


slope = 1


x =2

Ex 11.3(1): FI contracts, assessment

Solution has MRS = MRT
since there is no distortion the allocation (x*a, y*a), (x*b, y*b) is efficient

We cannot perturb the allocation so as to

make one person better off without making the other worse off

Ex 11.3 (2): Question

method: Derive the incentive-compatibility constraint Set up Lagrangean Solve using standard methods Compare with full-information values of x and y

Ex 11.3 (2): wrong contract?

Now it is impossible to monitor the lawyers type Is it still viable to offer the efficient contracts (x*a, y*a) and (x*b, y*b)? Consider situation of a type-a lawyer
if he accepts the contract meant for him he gets utility

but if he were to get a type-b contract he would get utility

So a type a would prefer to take

a type-b contract rather than the efficient contract

Ex 11.3 (2): incentive compatibility

Given the uncertainty about lawyers type the firm wants to maximise expected profits
it is risk-neutral

This must take account of the wrong-contract problem just mentioned An a-type must be rewarded sufficiently
so that is not tempted to take a b-type contract

The incentive-compatibility constraint for the a types

Ex 11.3 (2): optimisation problem

Let p be the probability that the lawyer is of type a Expected profits are

Structure of problem is as for previous exercises

participation constraint for type b will be binding

incentive-compatibility constraint for type a will be binding

This enables us to write down the Lagrangean

Ex 11.3 (2): Lagrangean

The Lagrangean for the firms optimisation problem is:

where l is the Lagrange multiplier for bs participation constraint m is the Lagrange multiplier foras incentive-compatibility constraint

Find the optimum by examining the FOCs

Ex 11.3 (2): Lagrange multipliers

Differentiate Lagrangean with respect to xa
and set result to 0

yields m = pta

Differentiate Lagrangean with respect to xb

and set result to 0

using the value for m this yields l = tb

Use these values of the Lagrange multiplier in the remaining FOCs

Ex 11.3 (2): optimal payment, a-types

Differentiate Lagrangean with respect to ya
and set result to 0

Substitute for m:

Rearranging we find
exactly as for the full-information case also MRS = 1, exactly as for the full-information case illustrates the no distortion at the top principle

Ex 11.3 (2): optimal payment, b-types

Differentiate Lagrangean with respect to yb
and set result to 0

Substitute for l and m:

Rearranging we find

this is less than [tb]2 the full-information income for a b-type

Ex 11.3 (2): optimal x

Differentiate Lagrangean with respect to l
and set result to 0 get the b-types binding participation constraint this yields which becomes

Differentiate Lagrangean with respect to m

and set result to 0 get the a-types binding incentive-compatibility constraint this yields

These are less than values for full-information contracts

for both a-types and b-types

Ex 11.3 (2): second-best solution

ub _ y
a-types reservation utility b-types reservation utility a-types full-info contract b-types second-best contract a-types second-best contract

^a y

ua _

^b y 0

^b x

^a x

Ex 11.3: points to remember

Standard adverse-selection results Full-information solution is fully exploitative
binding participation constraint for both types

Asymmetric information
incentive-compatibility problem for a-types

Second best solution

binding participation constraint for b-type binding incentive-compatibility constraint for a- type no distortion at the top