Introduction to contract theory - Adverse selection, moral hazard - Flashcards
(6 cards)
Contract theory or “theory of incentives” :
Analyze relations between agents that have different information
Models of adverse selection, or hidden information :
Agent is characterized by a type (e.g. preference, productivity); Type is unobserved by the principa
Models of moral hazard, or hidden action :
Agent can make different actions (e.g. decide a level of effort)
Principal does not observe the action of the agent but only the outcome of the action
The problem of the regulator (= principal): maximize socialwelfare under the constraint that the firm participates :
max (t;q) : (S(q) − t)
s:t: t − θq ≥ 0
Constraint is what we call participation constraint (PC) or individual rationality (IR)
Offering those two contracts is not the best strategy for the regulator, both types choose the same contract, we have :
pooling (mutualisation)
Mussa-Rosen model :
If imperfect information, high type has an incentive to buy the low quality
Second best choice of qualities: lowest quality will be distorted (i.e. lower than under perfect information)