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INCENTIVE THEORY
Lecture 2a: Adverse Selection - Screening With Two Types
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Introduction
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1. Preference Characteristics
q i v 0 (qi ) = P
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p i = Ti ! cqi ,
Si = q i v (qi ) ! cqi
s.t.
q i v (qi ) ! Ti % u
Ti& = q i v (qi& ) ! u
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qi = Di (p )
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pm = c +
D (p )
>c
!D 0 (p )
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p + q dp
dq = c or MR = MC
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D (p ) + SL0 (p )
>c
!D 0 (p )
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ICi
qi = arg max q i v (q ) ! T (q )
IRi
ui = q i v (qi ) ! T (qi ) % 0
s.t.
for i = L, H,
for i = L, H.
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ICH
ICL
IRH
IRL
s.t.
q H v (qH ) ! TH % q H v (qL ) ! TL ,
q L v (qL ) ! TL % q L v (qH ) ! TH ,
uH = q H v (qH ) ! TH % 0,
uL = q L v (qL ) ! TL % 0.
"
#
ICi : q i -type must prefer own contract (qi , Ti ) over other qj , Tj
IRi : each type must be willing to accept and participate
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ICH
IRL
s.t.
q H v (qH ) ! TH % q H v (qL ) ! TL ,
uL = q L v (qL ) ! TL % 0.
1
2
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q L v 0 (qLo ) =
c
> c,
m
m , 1!
1 ! b qH ! qL
<1
b
qL
q H >q L
IR
o
q H v (qH
) ! THo =H q H v (qLo ) ! TLo > q L v (qLo ) ! TLo =L 0
" #
" o#
show ICL is slack, i.e. q L v % q"Lo !# TLo %
q L#&
v qH
! THo
"
o
o
o
o
proof: use TH = TL + q H v qH ! v qL from%binding
" o # ICH ," o #&
and nd that ICL is equivalent to 0 % ! (q H ! q L ) v qH
! v qL
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q L v 0 (qLo ) =
c
> c,
m
m<1
o > qo
larger demand of buyer with high valuation, qH
L
o = q& ,
no distortion at top: demand of q H -type is rst best, qH
H
o
&
but consumption of q L -type is ineciently low, qL <
" qoL#
q H -type gets positive information rent (q H ! q L ) v qL ,
q L -type gets a surplus/rent of zero (IRH is slack, IRL is binding)!
information rent depends on demand qLo of low-type,
reducing allocation qLo relaxes ICH constraint, i.e.
makes mimicking by high type less attractive,
seller thereby reduces information rent and extracts even more
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Summary
Main insights: when agent has private information
principal: gets larger pay-o by clever design of contract menu
revelation principle: need no more than one contract per type
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