Chapter 4 The Adverse Selection Problem Stefan P. Schleicher University of Graz Economics of Information Incentives and Contracts

1.Introduction (1) Asymmetric information creates incentive to use information advantage Adverse selection problem Before signing the contract the principal has less information that the agent.

1.Introduction (2) N chooses the type of A which is only observed by A A accepts (or rejects) A supplies effort N determines state of the world Outcome and pay-offs P designs the contract n Agent’s action holds private information before the relationship has been initiated ä Informational asymmetry before contract has been signed depends on the agent’s type ä Examples Clients of an insurance Economic regulation

1.Introduction (3) Conflicting interests Agent tries to profit from his private information. Principal tries to reduce agent’s informational advantage.

2.A model of adverse selection (1) Principal risk-neutral contracts agent obtains expected payment 

2.A model of adverse selection (2) Agent risk-neutral or risk-avers effort e is verifiable 2 types – differ w.r.t. disutility of effort type 1 (G for good)v(e) type 2 (B for bad)kv(e), k > 0 utilities

2.A model of adverse selection (3) No asymmetric information Principal contracts G-agent Participation constraint Efficiency constraint

2.A model of adverse selection (4) No asymmetric information Principal contracts B-agent Participation constraint Efficiency constraint

2.A model of adverse selection (5) No asymmetric information

2.A model of adverse selection (6) No asymmetric information

2.A model of adverse selection (7) Asymmetric information Agents know their type, but the principal doesn’t both will choose B-contracts since If principal offers contracts Symmetric information contracts are not optimal under asymmetric information.

2.A model of adverse selection (8) Asymmetric information Requirements for contract design Menue of contracts that are self-selective Each agent must have an incentive to select the contract designed for him. Revelation principle Probability of an agent being type G is q 0 < q < 1

2.A model of adverse selection (9) [P 4.1 ] Participation constraints Self-selection or incentive compatibility constraints

2.A model of adverse selection (10) Results from the restrictions The principal needs to be concerned only with the participation restriction of the least efficient agent. At least the same effort is demanded of the most efficient agent as from the less efficient agents.

2.A model of adverse selection (11) Result 4.1 Solution of [P 4.1 ] for the menue of contracts:

2.A model of adverse selection (12) Characteristics of the optimal contract (a)Only the participation restriction for the inefficient agent binds, the efficient agent receives an informational rent. (b)Only the incentive restriction for the efficient agent binds. (c)The efficiency condition binds for the efficient agent. (d)A distortion is introduced into the efficiency condition of the inefficient agent.

2.A model of adverse selection (13) Agent G

2.A model of adverse selection (14) Agent B