Introduction to contract theory - Adverse selection, moral hazard -

Question 1

Contract theory or “theory of incentives” :

Answer 1

Analyze relations between agents that have different information

Question 2

Models of adverse selection, or hidden information :

Answer 2

Agent is characterized by a type (e.g. preference, productivity); Type is unobserved by the principa

Question 3

Models of moral hazard, or hidden action :

Answer 3

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

Question 4

The problem of the regulator (= principal): maximize socialwelfare under the constraint that the firm participates :

Answer 4

max (t;q) : (S(q) − t)
s:t: t − θq ≥ 0
Constraint is what we call participation constraint (PC) or individual rationality (IR)

Question 5

Offering those two contracts is not the best strategy for the regulator, both types choose the same contract, we have :

Answer 5

pooling (mutualisation)

Question 6

Mussa-Rosen model :

Answer 6

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)