Lecture 1: Hidden Information (Adverse Selection)

Question 1

In a contract, what two parties are involved?

Answer 1

a principal and an agent

Question 2

What/who is the principal?

Answer 2

The principal designs and offers a contract

Question 3

What/who is the agent?

Answer 3

The agent decides to accept or reject the contract offered

Question 4

Define Incentive compatible

Answer 4

A contract is incentive compatible if the agent truthfully reveals his type.
The principal has to leave some rents (surplus) to induce the agent to choose the the relevant contract

Question 5

When is trade efficient?

Answer 5

There is efficient trade only for the agent who is the best type (no distortion at the top).

Question 6

What are second best contracts?

Answer 6

Second best contracts occur due to incomplete information, there is too little trade: less than the optimal level of quantity or quality may be traded.

Question 7

What is the IR Contraint?

Answer 7

The IR constraint says what the player with the hidden type is thinking: I want to take my offer instead of not participate

Question 8

What is the IC Constraint?

Answer 8

IC = I want to take my offer instead of another offer for somebody else