ADVANCED MICROECONOMIC

THEORY
 ADVERSE SELECTION
 Adverse selection is a problem of ‘hidden knowledge’. If there are two ‘players’ in a
game, the principal and the agent, then adverse selection arises when the agent has
information relevant to their contract, but can hide it from the principal.

 An example would be in health care: an insurer is the principal and an insured is the
agent. The insurer can’t fully tell what risk the insured is, only the insured knows with
certainty.

 In the following model, we will show the contract arrangements that arise under
perfect information and the differences that happen under asymmetric information.

 In general, the optimal second-best contract calls for a distortion in the volume of
trade away from the first-best and for giving up some strictly rent to the most
efficient agents.

 Three assumptions:

 Both principal and agent are fully rational utility-maximising individuals.

 The probability distribution of an agent’s private information is common

knowledge.

 The principal moves first; they anticipate the agent’s behaviour and optimize
accordingly within the set of available contracts.
 ADVERSE SELECTION
 Setting up the model:

 Principal offers agent a contract based on the agent providing ‘q’ units of a good/service
in return for ‘t’ level of return. There are no commitment issues ex-post.

 t is a function of ‘q’: t = T(q).

 Timing: Agent discovers ability level  principal offers contract menu  agent accepts or
refuses contract  the contract is executed.

 The principal has a benefit function of S(q).

 Benefit function is concave and has diminishing returns: S’ > 0, S’’ < 0, S(0) = 0.

 All agents have a fixed cost ‘F’, that is common. They also have differing marginal costs,
with theta upper bar (ThetaUB) being high marginal cost (low ability – they are
inefficient), and theta lower bar (ThetaLB) being low marginal cost (high ability – they are
efficient).

 They can either be efficient with probability ‘v’, or inefficient with probability 1—v. The
cost functions are therefore:

C  q,     q  F w/ probability ' v'

 
C q,    q  F w/ probability '1- v'
 ADVERSE SELECTION

 In both models, only two contracts are ever offered.

 Let us assume that there are only two types of worker,
inefficient and efficient, with corresponding marginal costs
ThetaUB and ThetaLB.
 Both are associated with different levels of output – the
efficient guy has high output and the inefficient guy has low
output.
 As the reimbursement is a function of output, that means there
are only tw levels of reimbursement available.
 Hence, the only two contracts are as follows:

Inefficient  q, t  T q  q, t   
Efficient  q, t  T q  q, t   
 ADVERSE SELECTION

 The optimal full information contracts:

 The optimal full information contracts are derived by maximising the firm’s
expected profits subject to the constraints that remuneration has to be equal to
the costs incurred by workers (which the firm knows with certainty).

 The first order conditions show that the optimum is given where the principal’s
marginal benefit = agent marginal cost.

  
 max : v S q  t  1  v  S q  t
q , q , t ,t
 
s.t : t   q  F ; t   q  F
  
 max : v S q   q  F  1  v  S q   q  F
q ,q
 
 
*
 S' q  ; S' q    
*
 ADVERSE SELECTION

 Although the algebra is simple, a graphical explanation will help when considering
the second best, see the diagrams on the next slide.

 There are two types of indifference curves; one for the high ability and one for
the low ability; low ability’s curves are everywhere steeper than high ability’s.

 The utility of an agent is given by the difference between their remuneration and
their costs (let’s assume 0 fixed cost):

t  q  0; U  t  q
 The principal has non-linear curves, represented by its profit function:

  S  q   q
 The optimal contract arises when the agent’s indifference curve is tangential to
the principal’s.

 Under full information, the optimal points are A* and B*, with agents utilities
being reduced to 0, as the remuneration = cost.
 ADVERSE SELECTION
t
t t U  0  t q

U  t q
Increasing   S  q   q
C*
Utility
t*UB
B* U  0  t q
t*LB
A*
Increasing
Utility q q*UB q*LB q
Optimal first best and second best
q contract points.
Note that the remuneration depends
Agent’s indifference Principal’s indifference on the curvature of the profit function.
In this case, the more efficient worker
curves curves earns /less/ under the full information
A*, B* equilibrium.
 ADVERSE SELECTION
 Under full information, the principal will offer point A* to the efficient worker and B* to the
inefficient worker.

 However, if left to choose between them, BOTH would choose the B* contract.

 Note the blue dashed line on the 3rd diagram:

 The indifference curve that passes through point ‘B*’ gives a higher level of utility than the
one associated with A*.

 However, this is clearly not optimal. To induce the efficient worker to choose q*LB, the
principal must pay extra. This is called the INFORMATION RENT.

 This would be sufficient to make C* a plausible second best point.

 How large is the information rent?

t   q   t   q    q  I .R
The information rent is the vertical distance between the two indifference curves at q*UB:

* * *

 Because the information rent is dependent on q*UB, it may be optimal for the agent to
lower the level of services provided by the inefficient agent to compensate for the higher pay
of the efficient agent.
 ADVERSE SELECTION

 How to find the optimal second-best contract with adverse selection?

 As before, we maximise the expected profits of the principal.

 BUT: this time there are two more constraints;

 The PARTICIPATION CONSTRAINTS we had before (that each agent gets at least 0
utility – which are binding under full info).

 INCENTIVE COMPATABILITY CONSTRAINTS (each agent is at least as well-off on

their contract as they would be in choosing the other contract).

 If the available contracts satisfy these constraints, then those contracts are
INCENTIVE FEASIBLE.

 Note that it is possible for the inefficient type to have an optimal contract that is
(0,0), i.e., they are not employed by the principal. It is also possible that both
efficient and inefficient types share the same contract; there is a pooling/bunching
contract.

 The following slides mathematically derive the optimal contract with the added
constraints; we also respecify the variables to use utility levels instead of
remuneration levels.
 ADVERSE SELECTION

    
 max : v S q  t  1  v  S q  t   
 max : v S q   q 
q , q ,U ,U

q , q ,t ,t

s.t : t   q  0 1  v   S  q    q  
vU  1  v U 
Participation constraints
t  q  0
t  q  t  q  s.t : U  0 1
Incentive Compatability
U 0  2
t  q  t  q constraints
U  U   q  3
U  t   q; U  t   q U  U   q  4 
t  U   q; t  U   q The last term of the objective function shows
that asymmetric information has a direct effect
on the employer’s utility.
 ADVERSE SELECTION

 (1) and (4) imply (2).

 However, we can derive values for the different utilities from equations (3)
and (4); they implicitly give the identity:

 q  U  U   q
 Thus, it is not the actual values of utilities that matter, but the difference
between them. In this case, we may reduce the utility of the inefficient
person to 0.

 We are left with the constraint:

 q  U   q
 A profit maximising principal will reduce the utility of the agents to the
minimum possible, so the utilities will be:

U   q ; U  0
 ADVERSE SELECTION

 The problem now becomes one of unconstrained

optimisation:
 
max : v S q   q  1  v  S q   q  v q
q ,q
 
 Which yields first order conditions:
 
 F .O.C q : S ' q  
SB *
q q
   
 F .O.C q : 1  v  S ' q    v  0


S' q   
v
1  v 
SB *
q  q as S' '  0 (decreasing function)
SB * * SB SB SB
q q q q q q
 ADVERSE SELECTION

 Applying the framework:

 Identify:

 The principal and agent.

 Source of asymmetric information.

 Contract variables.

 Principal and agent’s utility functions.

 Incentive and Participation constraints.

 Once those have been identified, then the derivation is often similar, if not
exactly the same, as the baseline model. In particular, identify the
information rent and the level of distortion in ‘q’.

 The following slides have some applications from the textbook.

 ADVERSE SELECTION
 Regulation:

 Principal  Regulator, Agent  Monopoly firm

 Only the monopoly firm knows its true costs; regulators only know that
it can either be efficient or inefficient.

 Agent’s utility function  Profit: U = t-θq

 Principal’s utility function  A weighted average of consumer surplus

S(q)-t and monopoly’s profit, with a weighting of α on the profit.
 Thus, the objective function becomes:

  
max : v S q   q  1   U  1  v  S q   q  1   U 
 The constraints are the same as in the standard model; the results are
the same too, the most efficient type receives no distortion and the
least efficient type receives a downward distortion:

S' q SB
 
v1    
1 v
 ADVERSE SELECTION
 Price Discrimination (non linear pricing):

 Principal  Firm, Agent  Consumer.

 Only the consumer knows their preference parameter; the firm can
discriminate prices based on the quantity consumed to maximise
profits.

 Agent’s utility function: U = θu(q) – t

 Principal’s utility function: V = t – cq

 The only deviation from the model is that upper bars indicate the
‘efficient’ agents, that have strong preferences for the good. Hence, the
objective function is:
    
max : v  u q  c q  U  1  v   u q  c q  U 
 Constraints are the same, with the upper and lower bars swapped. The
conclusion is the same, but looks slightly different due to the objective
function; the second and first best values are below.


 
v 
 1 v  u ' q
*
 
c  
u ' q  c
*

 
 ADVERSE SELECTION
 The Revelation Principle:

 The revelation principle states that there is no loss of generality in restricting the
principal to offering contracts based on ability alone, as opposed to offering more
options, or allowing more communication between the principal and agent.

 We have been dealing with direct revelation mechanisms thus far:

 Direct revelation mechanism maps the skill level of the agent to a contract:

 g(θ) = (q(θ) ,t(θ))

 A direct revelation mechanism is truthful if it satisfies typical incentive

compatibility constraints (see below).


t     q   t    q    
t    q   t     q 
 More generally, you can have mechanisms which the agent reports to the
principal (and can be more complex), upon which the principal bases the contract:

 A mechanism maps the message of the agent:

 g̃(m) = (q̃ (m) ,t(̃ m))

 ADVERSE SELECTION
 Let m*(θ) be the optimal message for type θ. This implies the contract is better than
all other contracts:
 t(̃ m*(θ)) – θq̃ (m*(θ)) ≥ t(̃ m(θ)) – θq̃ (m(θ))

 The incentive compatibility constraints also need to be satisfied with m*(θ):

~   
t m *    q~ m *   ~   
t  m *      q~  m *    1
 Revelation Principle: With any mechanism, you may achieve the exact same allocation
achieved by a truthful direct revelation mechanism (there is no need to make
contracts more complicated, as you get the same result).
~
t    t  m *    Proof: Normal mechanisms are /indirect/. They first map abilities onto messages
(m*(θ)), before mapping those messages to contracts (g̃(m*(θ)). A direct revelation
q   q~  m *  
mechanism is the composition of those two functions: g = g₀m*. See the side
equations for the transfer and quantity functions.

 But is it truthful? It needs to satisfy the incentive compatibility constraint. Let us

transform equation (1) by using the equations at the side:

 
t    q   t     q  
 Therefore, the direct revelation mechanism is truthful and the principle holds.