ASE — Microeconomics II : Spring 2017

Assignment 2

Messan Agbaglah

June 18, 2017

Exercise I: Adverse Selection

Consider car sellers on a market of used cars. Each seller has exactly one used car to sell
and is characterised by the quality of the used car he wishes to sell. Suppose that α ∈ [0, 1]
represents the quality of a used car and assume that α is uniformly distributed on [0, 1].
The utility of a seller of type α who sells his car for a price p is us (p, α). If he fails to sell
his car, then his utility is 0.
Buyers of used cars receive utility α − p if they buy a car of quality α at price p and receive
utility 0 if they do not purchase a car.
There is asymmetric information regarding the quality of used cars. This is, sellers know
the quality of the car they are selling, but buyers do not know its quality. Assume that
there are not enough cars to supply all potential buyers.

1. Explain why in a competitive equilibrium under asymmetric information, we must

have E(α|p) = p.

2. Suppose that us (p, α) = p − α2 . Show that every price p ∈ (0, 12 ] is an equilibrium

price.
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3. Find the equilibrium price when us (p, α) = p − α. Describe which cars are traded
in equilibrium.

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 4. Find the equilibrium price when us (p, α) = p − α3 . How many equilibria are there in
this case?

5. Are any of the preceding outcomes Pareto efficient?

Exercise II: Adverse Selection

In this exercise, and in opposition to what we saw in class, we consider a market where the
buyer has private information about his valuation and the seller wants to extract all the
payoffs from the buyer.
Suppose the cost of producing q units of goods is c(q) = αi q, where αi ∈ {α0 , α1 } and
α1 > α0 . Only the seller knows the realization αi which the buyer cannot observe. This is,
the price of inputs the seller pays, can be low (α0 ) or high (α1 ), and only the seller knows
this information.
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The payoff to the buyer is b(qi ) − wi , where b(qi ) = 2qi2 is the utility generated from the
consumption of qi units of good, and wi the payment the buyer makes to the seller. Suppose
that α0 = 1, and α1 = 2. Suppose the probability with which α0 is realized is p, and the
probability with which α1 is realized is 1 − p. Assume that p = 0.5. Suppose the outside
option for both type of the seller is zero.

1. Suppose that information is symmetric. What is the objective function of the buyer?
What is the constraint the buyer faces? Find the optimal contract (i.e(wi , qi )). Which
type of agent has the incentive to lie?

2. Now information is asymmetric.

(a) Write down the optimization problem and the constraints the seller faces.

(b) Which constraints do not bind in equilibrium? Which constraints bind in equi-
librium?

(c) Find the optimal contract (i.e.(wi∗ , qi∗ )).

(d) Which type of the agent receives information rents? Compare the output levels
to the first best (situation where information is symmetric). Explain.

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Exercise III: Moral Hazard

In this exercise we consider the moral hazard insurance model. Each consumer has a von
√
Neumann-Morgenstern utility over wealth of u(w) = w. The initial wealth of the consumer
is w0 = 100. Suppose that in the case of accident, there are two loss levels, l = 0 and l = 51.
There are also two levels of effort described by e = 0, low effort, and e = 1, high effort. The
disutility of a consumer of effort e is d(e), where d(0) = 0 and d(1) = 13 . Finally, suppose
that the loss probabilities are given by the following table, where the rows correspond to
effort and the columns to loss levels.

So, for example, the probability that a loss of 51 occurs when the consumer exerts high
effort is 13 .

1. Verify that the probabilities given in the table satisfy the monotone likelihood ratio
property.

2. Find the consumer’s reservation utility assuming that there is only one insurance
company and that the consumer’s only other option is to self-insure.

3. Find the effort level that consumer will exert if no insurance is available?

4. Show that if information is symmetric, then it is optimal for the insurance company
to offer a policy that induces high effort. Show that this policy will not induce high
effort if information is asymmetric

5. What is the optimal policy if information is asymmetric?

6. Compare the insurance company’s profits in the symmetric and asymmetric informa-
tion cases. Also, compare the consumer’s utility in the two cases. Argue that the
symmetric information solution Pareto dominates that with asymmetric information.

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Exercise IV: Moral Hazard

This exercise models a Principal-Agent situation consisting of interactions between an in-

vestor and an entrepreneur with regards to the implementation of a project. The cost of
implementing the project is I = 5, and there are two possible outcomes for the project:
Success (S) and Failure (F ). The return is rS = 30 in the case of S and zero otherwise
(i.e., rF = 0). The entrepreneur can choose between working hard (eh ) and shirking (el ).
With eh , the probability with which S happens is ph = 0.6 and the utility cost for the
entrepreneur is dh = 2. On the other hand, with el , the probability with which F happens
is pl = 0.2 and the utility cost for the entrepreneur is dl = 0.
A contract is a combination (wS , wF ), specifying in which wi is the payment to the en-
trepreneur when the realization of the outcome is i ∈ {S, F }.
The investor is risk neutral, and his utility is v(w) = r − w.
√
The entrepreneur is risk averse, and his utility function is u(w) = 2 w − 2.
Remember that investor’s and entrepreneur’s utilities depend on the action taken by the
entrepreneur (i.e., eh or el ). The Entrepreneur’s outside option is zero.

1. Between the investor and an entrepreneur, who is the principal end who is the agent.
Justify your answer.

2. What is the expected utility V of the investor? Note that r and w depend on the
probabilities of Success or Failure, which in turn depend on the action (level effort)
chosen by the entrepreneur.

3. What is the net expected utility U of the entrepreneur? Note that w and the utility
cost (desutility) depend on the probabilities of Success or Failure, which in turn depend
on the action (level effort) chosen by the entrepreneur.

4. Symmetric information case: Suppose the investor can observe the entrepreneur’s
action. Write down the optimization problem and the constraints the investor faces.
Which action does the principal want the entrepreneur to choose? What is the optimal
contract? Is it profitable to implement this project (for the investor)?

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 5. Asymmetric information case: Suppose the investor cannot observe the entrepreneur’s
action. However, the realization of the project is observable and verifiable.

(a) If the investor wants the entrepreneur to choose eh , what is the optimization
problem? What are the constraints? What is the optimal contract?

(b) If the investor wants the entrepreneur to choose el , what is the optimization
problem? What are the constraints? What is the optimal contract?

(c) Which action does the investor want the entrepreneur to choose?

(d) Is it profitable to implement this project? What happens, if the investment cost
I = 13.

6. Suppose the investor cannot observe the entrepreneur’s action. However, the real-
ization of the project is observable and verifiable. Now, suppose that ph becomes
one. Namely, the success of the project is assured, when the entrepreneur works hard.
What is the best thing the investor can do in order to provide the good incentive
to his entrepreneur to work hard? Can the first best outcome (symmetric case) be
achieved?

Exercise V: Externalities and Public Goods

Nigerian Liquified Natural Gas Company is a natural gas company in Nigeria who owns
many pipelines running underneath what is now populated areas. The company can invest
u in the maintenance of the pipes. Maintenance affects two things. First, more maintenance
means that the gas company will lose less gas in the pipes. Assume that the value of lost
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gas is given by u so that more maintenance reduces the amount of lost gas. Second, more
maintenance means less damage to the land above the pipes. Assume that value of the
damage to the land above the pipes is given by 3. u1 , so that more maintenance decreases
the amount of damage to the land above.

1. What is the socially optimal (i.e. minimal cost) level of maintenance, u ? What is the
value of lost gas? What is the value of land damage? (This is the benchmark case.)

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2. What level of u is chosen by the gas company when no one owns the land above
the pipes? Now what is the value of lost gas? What is the value of land damage?
Compare the cost to the benchmark case.

3. Suppose now that the gas company owns the land above the pipes. What level of u
will they choose now? Is this optimal? If not, compare the cost to the benchmark
case.

4. Suppose now that Christelle Finagnon, an ordinary private citizen from Benin, owns
the property above the plant and can with no cost sue the natural gas company for
the losses to his property. What level of u will be chosen by the natural gas company?
How much will be paid from the gas company to Christelle Finagnon?

5. Suppose now that the courts are imperfect: For every 1 in actual damage, only 50% of
the damage can be recouped in court. So, if the true damage to Christelle Finagnon
L
is L, the gas company will only pay 2 .

(a) Suppose Christelle Finagnon owns the property. What level of u will be chosen
by the gas company? Is this efficient? If not, compare the cost to the benchmark
case.

(b) Suppose the gas company owns the property. What level of u will be chosen? Is
this efficient? If not, compare the cost to the benchmark case.

6. What is the lesson learned from the exercise?