Lecture Notes Microeconomic Theory

culminating in the theory of mechanism design. The theory of economic mechanismdesign which was originated by Hurwicz is very general. All economic mechanisms andsystems (including those known and unknown, private-ownership, state-ownership, andmixed-ownership systems) can be studied with this theory.At the micro level, the development of the theory of incentives has also been a majoradvance in economics in the last thirty years. Before, by treating the firm as a black boxthe theory remains silent on how the owners of firms succeed in aligning the objectives of itsvarious members, such as workers, supervisors, and managers, with profit maximization.When economists began to look more carefully at the firm, either in agricultural ormanagerial economics, incentives became the central focus of their analysis. Indeed, delegation of a task to an agent who has different objectives than the principal who delegatesthis task is problematic when information about the agent is imperfect. This problem isthe essence of incentive questions. Thus, conflicting objectives and decentralizedinformation are the two basic ingredients of incentive theory.We will discover that, in general, these informational problems prevent society fromachieving the first-best allocation of resources that could be possible in a world where allinformation would be common knowledge. The additional costs that must be incurredbecause of the strategic behavior of privately informed economic agents can be viewedas one category of the transaction costs. Although they do not exhaust all possibletransaction costs, economists have been rather successful during the last thirty years inmodelling and analyzing these types of costs and providing a good understanding of thelimits set by these on the allocation of resources. This line of research also providesa whole set of insights on how to begin to take into account agents’ responses to theincentives provided by institutions.We will briefly present the incentive theory in three chapters. Chapters 7 and 8consider the principal-agent model where the principal delegates an action to a single agentwith private information. This private information can be of two types: either the agentcan take an action unobserved by the principal, the case of moral hazard or hidden action;or the agent has some private knowledge about his cost or valuation that is ignored by theprincipal, the case of adverse selection or hidden knowledge. Incentive theory considerswhen this private information is a problem for the principal, and what is the optimal way3

for the principal to cope with it. The design of the principal’s optimal contract canbe regarded as a simple optimization problem. This simple focus will turn outto be enough to highlight the various trade-offs between allocative efficiencyand distribution of information rents arising under incomplete information.The mere existence of informational constraints may generally prevent the principal fromachieving allocative efficiency. We will characterize the allocative distortions that theprincipal finds desirable to implement in order to mitigate the impact of informationalconstraints.Chapter 9 will consider situations with one principal and many agents. Asymmetricinformation may not only affect the relationship between the principal and each of hisagents, but it may also plague the relationships between agents. Moreover, maintainingthe hypothesis that agents adopt an individualistic behavior, those organizational contextsrequire a solution concept of equilibrium, which describes the strategic interaction betweenagents under complete or incomplete information.4

Chapter 1Principal-Agent Model: HiddenInformation1.1IntroductionIncentive problems arise when a principal wants to delegate a task to an agent with privateinformation. The exact opportunity cost of this task, the precise technology used, andhow good the matching is between the agent’s intrinsic ability and this technology are allexamples of pieces of information that may become private knowledge of the agent. Insuch cases, we will say that there is adverse selection.Eexample1. The landlord delegates the cultivation of his land to a tenant, who will be the onlyone to observe the exact local weather conditions.2. A client delegates his defense to an attorney who will be the only one to know thedifficulty of the case.3. An investor delegates the management of his portfolio to a broker, who will privatelyknow the prospects of the possible investments.4. A stockholder delegates the firm’s day-to-day decisions to a manager, who will bethe only one to know the business conditions.5. An insurance company provides insurance to agents who privately know how gooda driver they are.6. The Department of Defense procures a good from the military industry without5

knowing its exact cost structure.7. A regulatory agency contracts for service with a Public Utility without havingcomplete information about its technology.The common aspect of all those contracting settings is that the information gap between the principal and the agent has some fundamental implications for the design of thecontract they sign. In order to reach an efficient use of economic resources, some information rent must be given up to the privately informed agent. At the optimal second-bestcontract, the principal trades off his desire to reach allocative efficiency against the costlyinformation rent given up to the agent to induce information revelation. Implicit here isthe idea that there exists a legal framework for this contractual relationship. The contractcan be enforced by a benevolent court of law, the agent is bounded by the terms of thecontract.The main objective of this chapter is to characterize the optimal rent extractionefficiency trade-off faced by the principal when designing his contractual offer to the agentunder the set of incentive feasible constraints: incentive and participation constraints. Ingeneral, incentive constraints are binding at the optimum, showing that adverse selectionclearly impedes the efficiency of trade. The main lessons of this optimization is thatthe optimal second-best contract calls for a distortion in the volume of tradeaway from the first-best and for giving up some strictly positive informationrents to the most efficient agents.1.21.2.1The Basic ModelEconomic Environment (Technology, Preferences, and Information)Consider a consumer or a firm (the principal) who wants to delegate to an agent theproduction of q units of a good. The value for the principal of these q units is S(q) whereS 0 0, S 00 0 and S(0) 0.The production cost of the agent is unobservable to the principal, but it is commonknowledge that the fixed cost is F and the marginal cost belongs to the set Φ {θ, θ̄}.The agent can be either efficient (θ) or inefficient (θ̄) with respective probabilities ν and6

1 ν. That is, he has the cost functionC(q, θ) θq Fwith probability ν(1.1)with probability 1 ν(1.2)orC(q, θ̄) θ̄q FDenote by θ θ̄ θ 0.1.2.2Contracting Variables: OutcomesThe contracting variables are the quantity produced q and the transfer t received by theagent. Let A be the set of feasible allocations that is given byA {(q, t) : q , t }(1.3)These variables are both observable and verifiable by a third party such as a benevolentcourt of law.1.2.3TimingUnless explicitly stated, we will maintain the timing defined in the figure below, where Adenotes the agent and P the principal.Figure 7.1: Timing of contracting under hidden information.Note that contracts are offered at the interim stage; there is already asymmetricinformation between the contracting parties when the principal makes his offer.7

1.3The Complete Information Optimal Contract(BenchmarkCase)1.3.1First-Best Production LevelsTo get a reference system for comparison, let us first suppose that there is no asymmetryof information between the principal and the agent. The efficient production levels areobtained by equating the principal’s marginal value and the agent’s marginal cost. Hence,we have the following first-order conditionsS 0 (q ) θ(1.4)S 0 (q̄ ) θ̄.(1.5)andThe complete information efficient production levels q and q should be both carried out if their social values, respectively W S(q ) θq F, and W S(q̄ ) θq̄ F , arenon-negative.SinceS(q ) θq S(q ) θq̄ S(q̄ ) θ̄q̄ by definition of θ and θ̄ θ, the social value of production when the agent is efficient, W , is greater than when he is inefficient, namely W .For trade to be always carried out, it is thus enough that production be sociallyvaluable for the least efficient type, i.e., the following condition must be satisfiedW̄ S(q̄ ) θ̄q̄ F 0.(1.6)As the fixed cost F plays no role other than justifying the existence of a single agent, itis set to zero from now on in order to simplify notations.Note that, since the principal’s marginal value of output is decreasing, the optimalproduction of an efficient agent is greater than that of an inefficient agent, i.e., q q̄ .1.3.2Implementation of the First-BestFor a successful delegation of the task, the principal must offer the agent a utility levelthat is at least as high as the utility level that the agent obtains outside the relationship.8

We refer to these constraints as the agent’s participation constraints. If we normalize tozero the agent’s outside opportunity utility level (sometimes called his quo utility level),these participation constraints are written ast θq 0,(1.7)t̄ θ̄q̄ 0.(1.8)To implement the first-best production levels, the principal can make the followingtake-it-or-leave-it offers to the agent: If θ θ̄ (resp. θ), the principal offers the transfert̄ (resp. t ) for the production level q̄ (resp. q ) with t̄ θ̄q̄ (resp.t θq ). Thus,whatever his type, the agent accepts the offer and makes zero profit. The completeinformation optimal contracts are thus (t , q ) if θ θ and (t̄ , q̄ ) if θ θ̄. Importantly,under complete information delegation is costless for the principal, who achieves the sameutility level that he would get if he was carrying out the task himself (with the same costfunction as the agent).Figure 7.2: Indifference curves of both types.9

1.3.3A Graphical Representation of the Complete InformationOptimal ContractFigure 7.3: First best contracts.Since θ̄ θ, the iso-utility curves for different types cross only once as shown in theabove figure. This important property is called the single-crossing or Spence-Mirrleesproperty.The complete information optimal contract is finally represented Figure 7.3 by thepair of points (A , B ). Note that since the iso-utility curves of the principal correspondto increasing levels of utility when one moves in the southeast direction, the principalreaches a higher profit when dealing with the efficient type. We denote by V̄ (resp.V ) the principal’s level of utility when he faces the θ̄ (resp. θ ) type. Because theprincipal’s has all the bargaining power in designing the contract, we have V̄ W (resp.V W ) under complete information.10

1.41.4.1Incentive Feasible ContractsIncentive Compatibility and ParticipationSuppose now that the marginal cost θ is the agent’s private information and let us considerthe case where the principal offers the menu of contracts {(t , q ); (t̄ , q̄ )} hoping that anagent with type θ will select (t , q ) and an agent with θ̄ will select instead (t̄ , q̄ ).From Figure 7.3 above, we see that B is preferred to A by both types of agents.Offering the menu (A , B ) fails to have the agents self-selecting properly within this menu.The efficient type have incentives to mimic the inefficient one and selects also contractB . The complete information optimal contracts can no longer be implemented underasymmetric information. We will thus say that the menu of contracts {(t , q ); (t̄ , q̄ )} isnot incentive compatible.Definition 1.4.1 A menu of contracts {(t, q); (t̄, q̄)} is incentive compatible when (t, q)is weakly preferred to (t̄, q̄) by agent θ and (t̄, q̄) is weakly preferred to (t, q) by agent θ̄.Mathematically, these requirements amount to the fact that the allocations must satisfythe following incentive compatibility constraints:t θq t̄ θq̄(1.9)t̄ θ̄q̄ t θ̄q(1.10)andFurthermore, for a menu to be accepted, it must satisfy the following two participationconstraints:t θq 0,(1.11)t̄ θ̄q̄ 0.(1.12)Definition 1.4.2 A menu of contracts is incentive feasible if it satisfies both incentiveand participation constraints (1.9) through (1.12).The inequalities (1.9) through (1.12) express additional constraints imposed on the allocation of resources by asymmetric information between the principal and the agent.11

1.4.2Special CasesBunching or Pooling Contracts: A first special case of incentive feasible menu ofcontracts is obtained when the contracts targeted for each type coincide, i.e., when t t̄ tp , q q̄ q p and both types of agent accept this contract.Shutdown of the Least Efficient Type: Another particular case occurs when oneof the contracts is the null contract (0,0) and the nonzero contract (ts , q s ) is only acceptedby the efficient type. Then, (1.9) and (1.11) both reduce tots θq s 0.(1.13)The incentive constraint of the bad type reduces to0 ts θ̄q s .1.4.3(1.14)Monotonicity ConstraintsIncentive compatibility constraints reduce the set of feasible allocations. Moreover, thesequantities must generally satisfy a monotonicity constraint which does not exist undercomplete information. Adding (1.9) and (1.10), we immediately haveq q̄.(1.15)We will call condition (1.15) an implementability condition that is necessary and sufficientfor implementability.1.5Information RentsTo understand the structure of the optimal contract it is useful to introduce the conceptof information rent.We know from previous discussion, under complete information, the principal is ableto maintain all types of agents at their zero status quo utility level. Their respectiveutility levels U and Ū at the first-best satisfyU t θq 012(1.16)

andŪ t̄ θ̄q̄ 0.(1.17)Generally this will not be possible anymore under incomplete information, at least whenthe principal wants both types of agents to be active.Take any menu {(t̄, q̄); (t, q)} of incentive feasible contracts and consider the utilitylevel that a θ-agent would get by mimicking a θ̄-agent. The high-efficient agent would gett̄ θq̄ t̄ θ̄q̄ θq̄ Ū θq̄.(1.18)Thus, as long as the principal insists on a positive output for the inefficient type, q̄ 0,the principal must give up a positive rent to a θ-agent. This information rent is generatedby the informational advantage of the agent over the principal.We use the notations U t θq and Ū t̄ θ̄q̄ to denote the respective informationrent of each type.1.6The Optimization Program of the PrincipalAccording to the timing of the contractual game, the principal must offer a menu ofcontracts before knowing which type of agent he is facing. Then, the principal’s problemwrites asmax{(t̄,q̄);(t,q)}ν(S(q) t) (1 ν)(S(q̄) t̄)subject to (1.9) to (1.12).Using the definition of the information rents U t θq and Ū t̄ θ̄q̄, we can replacetransfers in the principal’s objective function as functions of information rents and outputsso that the new optimization variables are now {(U , q); (Ū , q̄)}. The focus on informationrents enables us to assess the distributive impact of asymmetric information, and thefocus on outputs allows us to analyze its impact on allocative efficiency and the overallgains from trade. Thus an allocation corresponds to a volume of trade and a distributionof the gains from trade between the principal and the agent.With this change of variables, the principal’s objective function can then be rewrittenasν(S(q) θq) (1 ν)(S(q̄) θ̄q̄) (νU (1 ν)Ū ) .{z} {z} 13(1.19)

The first term denotes expected allocative efficiency, and the second term denotes expectedinformation rent which implies that the principal is ready to accept some distortions awayfrom efficiency in order to decrease the agent’s information rent.The incentive constraints (1.9) and (1.10), written in terms of information rents andoutputs, becomes respectivelyU Ū θq̄,(1.20)Ū U θq.(1.21)The participation constraints (1.11) and (1.12) become respectivelyU 0,(1.22)Ū 0.(1.23)The principal wishes to solve problem (P ) below:max{(U ,q);(Ū ,q̄)}ν(S(q) θq) (1 ν)(S(q̄) θ̄q̄) (νU (1 ν)Ū )subject to (1.20) to (1.23).We index the solution to this problem with a superscript SB, meaning second-best.1.71.7.1The Rent Extraction-Efficiency Trade-OffThe Optimal Contract Under Asymmetric InformationThe major technical difficulty of problem (P ) is to determine which of the many constraints imposed by incentive compatibility and participation are the relevant ones. i.e.,the binding ones at the optimum or the principal’s problem.Let us first consider contracts without shutdown, i.e., such that q̄ 0. This is truewhen the so-called Inada condition S 0 (0) is satisfied and limq 0 S 0 (q)q 0.Note that the θ-agent’s participation constraint (1.22) is always strictly-satisfied. Indeed, (1.23) and (1.20) immediately imply (1.22). (1.21) also seems irrelevant becausethe difficulty comes from a θ-agent willing to claim that he is inefficient rather than thereverse.14

This simplification in the number of relevant constraints leaves us with only two remaining constraints, the θ-agent’s incentive constraint (1.20) and the θ̄-agent’s participation constraint (1.23), and both constraints must be binding at the optimum of theprincipal’s problem (P ):U θq̄(1.24)Ū 0.(1.25)andSubstituting (1.24) and (1.25) into the principal’s objective function, we obtain a reducedprogram (P 0 ) with outputs as the only choice variables:max ν(S(q) θq) (1 ν)(S(q̄) θ̄q̄) (ν θq̄).{(q,q̄)}Compared with the full information setting, asymmetric information alters the principal’soptimization simply by the subtraction of the expected rent that has to be given up to theefficient type. The inefficient type gets no rent, but the efficient type θ gets informationrent that he could obtain by mimicking the inefficient type θ. This rent depends only onthe level of production requested from this inefficient type.The first order conditions are then given byS 0 (q SB ) θor q SB q .(1.26)and(1 ν)(S 0 (q̄ SB ) θ̄) ν θ.(1.27)(1.27) expresses the important trade-off between efficiency and rent extraction which arisesunder asymmetric information.To validate our approach based on the sole consideration of the efficient type’s incentiveconstraint, it is necessary to check that the omitted incentive constraint of an inefficientagent is satisfied. i.e., 0 θq̄ SB θq SB . This latter inequality follows from themonotonicity of the second-best schedule of outputs since we have q SB q q̄ q̄ SB .In summary, we have the following proposition.Proposition 1.7.1 Under asymmetric information, the optimal menu of contracts entails:15

(1) No output distortion for the efficient type test in respect to the first-best,q SB q . A downward output distortion for the inefficient type, q̄ SB q̄ withS 0 (q̄ SB ) θ̄ ν θ.1 ν(1.28)(2) Only the efficient type gets a positive information rent given byU SB θq̄ SB .(1.29)(3) The second-best transfers are respectively given by tSB θq θq̄ SB andt̄SB θ̄q̄ SB .1.7.2A Graphical Representation of the Second-Best OutcomeFigure 7.4: Rent needed to implement the first best outputs.Starting from the complete information optimal contract (A , B ) that is not incentivecompatible, we can construct an incentive compatible contract (B , C) with the same16

production levels by giving a higher transfer to the agent producing q as shown in thefigure above. The contract C is on the θ- agent’s indifference curve passing through B .Hence, the θ-agent is now ind

Lecture Notes Microeconomic Theory Parts I-II Guoqiang TIAN Department of Economics Texas A&M