INTRODUCTION TO INCENTIVE THEORY

Jean-Jacques Laont & David Martimort

October 21, 2003
2
EXERCISES
I- ADVERSE SELECTION
Lending with adverse selection
There is a continuum of risk neutral borrowers with no personal wealth and limited
liability. A proportion of borrowers (called type 1) have sure projects with return h for
an investment of 1. A proportion 1 of borrowers (called type 2) have (stochastically
independent) projects with return h only with probability in (0, 1) and return 0 with
probability 1 , for an investment of 1. If he does not apply for a loan, the borrower
has an outside opportunity utility level of u.
There is a single risk neutral bank available for loans which has a nancing cost of r.
The bank oers contracts to maximize its expected prot. For simplicity, we assume that
all projects are socially valuable, i.e.,
h > r + u
1- Explain why there is no loss of generality in considering the menus of contracts
(r
1
, P
1
), (r
2
, P
2
) where P
i
is the probability of obtaining a loan and r
i
is the repayment to
the bank when the investment succeeds if the borrower announces that he is of type i.
2- Write the maximization program of the bank which chooses the menu {(r
1
, P
1
); (r
2
, P
2
)}
to maximize its expected prot under the borrowers participation and incentive con-
straints (for simplicity assume that if a borrower applies for a loan he loses his outside
opportunity u).
3- Show that the optimal contract entails a non-random allocation of loans (i.e., P
i
is
either 0 or 1, i = 1, 2). Characterize the optimal contract. Discuss its properties.
3
4 EXERCISES
Bundling with Asymmetric Information
We consider a continuum of consumers who have the following independent willing-
nesses to pay for goods 1 and 2 and desire only one unit of each good. For each good, a
consumer has an equal probability of having valuations , or + (with > ).
The two goods are sold by a monopolist who has a zero marginal cost for each of them.
1- Determine the optimal pricing policy for each good and the associated revenue. In this
exercise consider only deterministic pricing strategies.
2- Suppose that the monopolist can oer only a bundle of the two goods at a price P
B
.
Determine the optimal P
B
and show conditions under which it raises more revenue than
the optimal single good prices.
3- Show that there exist prices for the bundle of the goods which improve revenue even in
the presence of the optimal single good prices. (Hint: Draw the table of the surpluses that
the dierent types of consumers derive from the optimal single prices with the associated
prots of the monopoly. Exhibit a price for the bundle which attracts some consumers
and makes more revenue from these consumers than the optimal single good prices).
5
Incentives and aid
We consider the problem of the North willing to aid the poor in the South.
The utility function of a representative agent in the North is
V
N
= q
N
+ n
P
v(q
P
), v

> 0, v

< 0
where q
N
is the consumption, n
P
is the number of poor in the South and q
P
is the per
capita consumption of the poor in the South. Each agent of the North has an endowment
of y
N
. The consumption of the poor exerts a positive externality on the rich in the North
who are n
N
in number.
The representative rich of the South has the utility function
U = q
R
+ n
P
v(q
P
)
where q
R
is his consumption and in {,

} a parameter describing how altruistic the rich
in the South are. There are n
R
rich in the South, each one with an endowment of y
R
.
The preference parameter is private information of the rich in the South. Given
that the North must use the rich in the South as an intermediary (because they control
the government) to help the poor we want to study how the incomplete information on
aects the optimal level of aid chosen by the North.
1- Suppose rst that the South lives in autarky and that the poor of the South are only
helped by the rich in the South. We assume that the poor have no endowment.
Determine the optimal level of aid q
A
P
when it is determined by a representative rich
of the South. The corresponding level of utility obtained by the rich will be called the
status quo utility level U
A
(). Special case : v() = log().
2- Suppose rst that the North knows and brings to the South a level of aid n
R
a
to increase the incentives of the rich in the South to help the poor. Show that if a
is unconditional it does not aect the level of aid. Determine the optimal level of aid
when a can be made conditional on the consumption level of the poor q
P
. Special case :
v() = log()
3- Assume now that the North does not know and let = Pr( =

). Determine the
optimal menu of contracts ( a, q
P
); (a, q
P
), specifying aid conditional on the consumption
of the poor, which maximizes the expected utility of the North under the incentive and
participation constraints of the South. Discuss. Special case : v() = log()
6 EXERCISES
Downsizing a Public Firm
We consider a public rm which is producing a public good with a continuum of
workers of mass 1. Each worker produces one unit of public good. A mass q in [0, 1] of
workers produces an output q which has social value
S(q), with S

> 0 and S

< 0.
New outside opportunities appear for workers, calling for a downsizing of the public
rm. Let
i
the outside utility level that worker i can obtain.
i
can take one of two
positive values {,

} with =

> 0. These outside opportunities are identically
and independently distributed between workers on {,

} with = Pr(
i
= ) and 1 =
Pr(
i
=

).
A new allocation of labor is characterized by the proportions p (resp. p) of workers of
type (resp.

) who remain in the public rm. Assuming that workers are risk-neutral,
a downsizing mechanism can be viewed as a pair of contracts {(p, t); ( p,

t)} specifying for

each announcement or

, a probability to remain in the public rm and a payment
(unconditional on remaining or not in the public rm).
Total production of the public rm is then q = p +(1 ) p. Let us rst assume that
the values of outside opportunities are public knowledge. In other words the government
is under complete information. The workers accept to play the downsizing mechanism
if the government pays them, t for type ,

t for type

and satises their participation
constraints
t + (1 p) , or t p,

t + (1 p)

, or

t p

.
If there is a cost 1 + of public funds, social welfare is equal to:
S(p + (1 ) p) Social value of the public good
(1 + )(t + (1 )

t) Social cost of transfers

+(t + (1 p)) Welfare of workers.
+(1 )(

t + (1 p)

)
If > 0, the participation constraints are binding and social welfare can be reduced
to
S(p + (1 ) p) (1 + )(p + (1 ) p

) + + (1 )

.
7
The social optimum is then characterized by:
if S

() > (1 + )

,
S

( + (1 ) p) = (1 +)

and p = 1,
if (1 + )

> S

() > (1 + ),
p = 1 and p = 0,
if S

() < (1 + ),
S

(p) = (1 +) and p = 0.
From now on, we suppose that the values of the outside opportunities are observed by
the workers, and not by the government.
A downsizing mechanism {(p, t); ( p,

t)} is incentive compatible if and only if

t + (1 p)

t + (1 p)

t + (1 p)

t + (1 p).
It satises the participation constraint if

t + (1 p)

t + (1 p) .
1- Discuss these constraints and show that one condition is redundant with the other
three conditions.
2- We will say that an allocation of labor (p, p) can be implemented if there exists a
pair of transfers (t,

t) such that the downsizing mechanism {(p, t); ( p,

t)} satises all the

incentive compatibility and participation constraints.
a) Show that (p, p) can be implemented if and only if p p.
b) For any implementable (p, p), what is the pair of transfers (t,

t) that minimizes the

social cost of transfers?
3- Determine the allocation of labor and the transfers that maximize expected social
welfare. Distinguish three cases according to the value of S

().
4- Is it possible to structure the payments in such a way that each type does not regret
to have participated in the mechanism? (Hint: dierentiate the payments between those
who stay and those who leave)
5- Suppose that workers dier by the quality of their production in the public rm. A
type

worker produces units of public good while a type worker still produces one
8 EXERCISES
unit. Characterize the allocation of labor which maximizes expected social welfare when
>

.
9
Labor Contracts
A rm designs a labor contract for a worker. The utility function of the worker is,
U
A
= u(c) l, where c is consumption and l is labor supply, in {,

} is the preference
parameter known to the worker and u() in an increasing concave function; <

. The
proportion of workers with low disutility of eort, = , is . The agents optimal choice
must satisfy the budget restriction c t, where t is the payment he receives from the
rm. The rm has the following utility function: U
P
= f(l)t, where f(l) is a decreasing
returns to scale production function.
1- Assume the rm knows . Characterize the solution to the rms problem which
maximizes its utility function under the participation constraint of the worker. Call this
solution the First-Best solution.
2- Now assume that labor supply is observed by the employer (and is veriable), but
neither U nor are observed by him. Show that the First-Best solution is not imple-
mentable. The rm can now oer menus of contracts: (

t,

l) and (t, l), where (

t,

l) is the
contract chosen by the worker with disutility of eort

and (t, l) is the contract for l.
Find the optimal contract. Compare this (Second-Best) solution to the First-Best.
3- Now suppose that the worker with low disutility of eort has an outside opportunity
that gives him a utility level of V . Characterize the rst-best and second-best (asymmetric
information) solutions in this case. Take into account that the solution will depend on the
size of V . For =

, consider the cases in which

l
SB
V (SB = second-best),

l
SB
V t

( = rst-best),

l

V l

and V l

. Which are the

binding constraints in each case and what type of distortion is needed?
10 EXERCISES
Control of a Self-Managed Firm
Consider a rm that has a production function
y = l
1/2
,
where l is the number of workers (considered to be a continuous variable: l in R
+
) and
> 0 is a productivity parameter known by the rm. There are xed costs of production
A. Let p be the price of the good produced competitively by the rm.
1- Assume that the rm is managed by the workers and that its objective function is
U
SM
=
py A
l
.
Determine the optimal size (for workers) of the self-managed rm.
2- Let w be the competitive wage rate in the rest of the economy, so that w is the
opportunity cost of labor in this economy. What is the optimal allocation of labor? What
happens if w is too large? Why is the size of the self-managed rm not optimal in general?
3- Assume that the government knows . Consider the case in which w is small enough
to justify the presence of a self-managed rm. Compute the per unit tax on the good
produced by the rm that restores the optimal allocation of labor. Show that we could
also use a lump-sum tax T on the revenue of the self-managed rm to achieve the same
objective. (Assume that the rm is of negligible size with respect to the rest of the
economy).
4- Suppose now that the government does not know which can take one of two values
or

with =

> 0. It uses a regulatory mechanism (l(

), t(

)) which associates
a labor input l(

) and a transfer t(

) to the rms announcement

. The rms objective
is now
U
SM
=
p(l(

))
1/2
+ t(

) A
l(

)
.
Characterize the set of regulatory mechanisms which induce truthful revelation of .
Derive the implementability condition on .
5- Assume that = Pr( = ). Suppose that the government wishes to maximize the
expectation of
U
G
= pl
1/2
wl.
Show that the solution of this problem does not satisfy the implementability condition;
so that the rst-best is not implementable even if transfers are costless to the government.
11
What is then the optimal regulatory mechanism, when the labor managed rm has a zero
outside opportunity level of utility?
12 EXERCISES
Information and Incentives
An agent (natural monopoly) produces a quantity q of a good at a variable cost q
with in {,

}, =

. The principal gets an utility S(q)(S

> 0, S

< 0) from this

production and gives a transfer t to the agent.
The principals utility function is V = S(q) t and the agents utility function is
U = t q. Furthermore, the agents status quo utility payo is normalized at 0.
1- Characterize the optimal contract of the principal under complete information about
.
2- is now private information of the agent and = Pr( = ). Characterize the
optimal contract of the principal under incomplete information with interim participation
constraints of the agent (suppose here and later that the value of the project is large
enough so that the principal always wants to obtain a positive level of production).
3- Suppose now that the principal has access to the information technology which allows
him to receive a signal in {, } with
= Pr( = | = ) = Pr( = | =

)
1
2
.
Determine the updated principals beliefs about the eciency of the agent, that is
= Pr( = | = ); = Pr( = | = ).
Characterize the optimal contract for each .
4- Show that an increase of corresponds to an improvement of information in the sense
of Blackwell.
5- Show that an increase of has two eects on the principals expected utility, the
classical eect (that we will call the Blackwell eect) and an eect due to the direct
impact of on the expected utility of the principal conditional on .
6- Show that nevertheless the expected utility of the principal increases with .
13
The Bribing Game
We consider an administration which is supposed to deliver with some xed delay a
service to the citizens (passport, permits,...). With the normal functioning of the admin-
istration, citizens derive a benet u
0
which depends on their valuation of time.
With some additional eort the ocial can deliver the service with a shorter delay.
Let us call q the decrease of delay that the ocial can provide at a cost
(qQ)
2
2
for him
where Q is a constant.
We assume that there is a proportion (resp. 1 ) of type 1 (resp. type 2) citizens
who derive a benet from a decrease q of delay equal to q(

q). Citizens are willing to

bribe the ocial to decrease of delays.
Characterize the optimal bribing contract that the ocial will oer to the citizens.
14 EXERCISES
Regulation of Pollution
We consider a rm which has a revenue R, but creates a level of pollution x from
its activities. The damage created by the level of pollution x is D(x) with D

(x) >
0, D

(x) 0. The production cost of the rm is C(x, ), with C

x
< 0, C
xx
> 0 and is
a parameter known only to the rm. can take two values {,

} and = Pr( = ) is
common knowledge.
1- The level of pollution x

() corresponding to the complete information optimum is

characterized by
D

(x) + C
x
(x, ) = 0.
Show that, if the regulator is not obliged to satisfy a participation constraint of the rm,
he can implement x

() by asking a transfer equal to the cost of damage up to a constant.

2- Suppose now that the rm can refuse to participate (but in this case has a zero utility
level) and assume that the regulator has (up to a constant) the following objective function
W = D(x) (1 + )t + t C(x, ) (1)
where t is the transfer from the regulator to the rm and 1 + is the opportunity cost of
social funds. When the regulator must satisfy the rms participation constraint
t C(x, ) 0 for all ,
characterize the decision rule x(), in {,

}, which maximizes W under complete infor-
mation. Compare with question 1.
3- We assume in addition that C

< 0 and C
x
< 0. Determine the menu of contracts
(t, x), (

t, x) which maximizes the expectation of (1) under participation and incentive

constraints of the rm.
4- Optional. Same problem when is distributed according to the distribution F() with
density f() on the interval [,

] with
d
d

1 F()
f()

< 0, C
xx
0 and C
x
0.
15
Taxation of a Monopoly
We consider a monopoly facing a continuum [0, 1] of consumers. Each consumer is
characterized by his utility function, log q + x, where x is his consumption of good 1
(chosen as the numeraire) and q is his consumption of good 2 produced by the monopoly.
The parameter can take two values or

with

= 1 and let be the common
knowledge proportion of type consumers.
Consumers have large resources in good 1, x

, so that their behavior is always char-

acterized by the rst-order conditions of their optimization programs.
The monopoly has a variable cost function C(q) = cq and must incur a xed cost K.
1- Explain why the prole of consumption q

(), in {,

} which corresponds to an
interior Pareto optimal allocation is the solution of:
max [ log q() + x()] + (1 )

log q(

) + x(

,
subject to
x() + (1 )x(

) = x c

q() + (1 )q(

K.
Determine q

().
2- Let {(q, t); ( q,

t)} the direct revelation mechanism which elicits the parameters from
consumers. Characterize the direct revelation mechanisms which are truthful.
3- Write the optimization program of the monopoly when he is constrained to provide a
non negative utility level to each consumer
log q() t() 0 for in {,

}.
Characterize the truthful direct revelation mechanism which is optimal for the monopoly.
4- The government uses now a linear tax on the consumption of good 2 to control the
monopoly. Assuming that the government maximizes a weighted average of consumers
utility functions (with a weight 1), of the monopolys prots (with a weight larger than
1) and of taxes (with a weight > 0 such that ), show that the optimal tax is
negative.
5- Optional. Questions 2 and 3 when is distributed according to the distribution F()
with positive density f() on the interval [,

] with
d
d

1F()
f()

< 0. Consider the special

case of a uniform distribution on [2, 3] and c = 1 and obtain the associated nonlinear
price.
16 EXERCISES
Shared Information Goods, Majority Voting and Op-
timal Pricing
We consider a group of three consumers who share or not an information good sold
by a monopolist who has a zero marginal cost.
Let
i
q
q
2
2
t the utility function of consumer i, i = 1, 2, 3 where q is the quantity of the
good and t the payment. The
i
are independently drawn from the uniform distribution
on [1, 2] and private information of the consumers.
1- Assuming rst that the monopolist can prevent the consumers to share the good, char-
acterize the optimal pricing policy of the monopolist (under the simplifying assumption
that almost all consumers must have a non-zero consumption level).
2- Suppose now that consumers share the good and the payment. Assuming that demand
is determined by the median consumer, characterize the optimal pricing policy of the
monopolist (hint 1: assume that, for the optimal pricing, consumers have single peaked
preferences and check it ex post), (hint 2: the distribution function G() of the median of
three independent draws from the distribution F() is: G(x) = [F(x)]
2
[3 2F(x)]).
3- Show that the expected prot of the monopolist is higher when consumers share the
good.
17
Labor Contract with Adverse Selection
We consider a principal-agent relationship in which the principal is an employer and
the agent is a worker.
For a production level y the worker of type ( in {,

}) suers a disutility of working
equal to
(y).
In other words, a worker of type must work units of labor (with = y) which
create a disutility of labor (),

() > 0,

() 0.
If he receives a compensation t from the employer his net utility is U = t (y).
The employers utility function is V = y t.
1- Apply the Revelation Principle and characterize the truthful direct revelation mecha-
nisms.
2- Assume now that (resp. (1 )) equals the probability that the worker is of type
(resp.

). Characterize the optimal contract of an employer who maximizes his expected
utility under the incentive and interim participation constraint of the worker.
18 EXERCISES
II- MORAL HAZARD
Lending with moral hazard
We consider a cashless entrepreneur who wants to borrow and carry out the following
project. With an investment normalized to 1 unit he will get an output of z with prob-
ability

P > 0 if he exerts an eort level of e and with probability P > 0 (

P > P) if he
exerts no eort, and nothing otherwise. Let the cost of eort e for the entrepreneur.
Furthermore his status quo utility level is normalized to 0 and Pz < r.
A monopolistic bank with cost of fund r oers a loan of 1 unit for a reimbursement of
z x when the project is successful, where x is the share of production retained by the
agent.
Determine the optimal loan contract of a bank which maximizes its expected prot
under the incentive and participation constraints of the entrepreneur.
19
Moral Hazard and Monitoring
An entrepreneur who has no cash and no assets wants to nance a project which
costs I > 0. The project yields R with probability p and 0 with probability 1 p. This
probability of success depends upon the eort e in {e
H
, e
L
} of the entrepreneur: it is p
H
if eort is high (e
H
) and p
L
if e = e
L
; 1 > p
H
> p
L
= 0. A loan contract species a given
payment P if the income is R and 0 if the income is 0.
The entrepreneur enjoys a private benet B > 0 if eort is low and 0 if eort is high.
There is a competitive loan market and the economys rate of interest is equal to 0.
1- Show that the project is nanced if and only if
p
H
R B + I (1)
2- Suppose that (1) is not satised but p
H
R > I. Introduce a monitoring technology.
By spending m > 0, the lender can catch the entrepreneur if the eort is low and reverse
the decision to obtain a high level of eort; in this case the entrepreneur is punished and
receives 0. The lender and the entrepreneur choose simultaneously whether to monitor
and whether to select a high eort level. The expected payo matrix for this game is
thus:
e e
Monitor p
H
P m, p
H
(R P)) (p
H
R m, 0)
Not monitor (p
H
P, p
H
(R P)) (0, B)
Assume m < p
H
R < B.
a. Show that the only equilibrium for P < R is in mixed strategies. Find the
equilibrium strategies.
b. Argue that the project is nanced if and only if:
p
H
R m + I.
20 EXERCISES
Inducing Information Learning
We consider a principal-agent problem in which the risk-neutral principal wants to
delegate to a cashless risk-neutral agent protected by limited liability, the acquisition of
soft information about the quality of a risky project as well as the decision to engage or
not in the risky project.
There is a safe project which yields 0 to the principal with probability 1. There is also
a risky project. In the absence of information, the risky project yields

S with probability
and S with probability 1 . We will assume that

S + (1 )S = 0.
By incurring an eort with cost , the agent can learn a signal {, } on the
future realization of the risky project.
We will assume that Pr( |

S) = Pr(|S) = , with ]
1
2
, 1] being interpreted as the
precision of the signal.
1- As a benchmark, suppose that the principal uses the technology for information gath-
ering himself. Show that the project is done only when is observed. Write the condition
under which the learning of information is optimal.
2- Suppose now that the agent decides to adopt or not the risky project. The principal
uses a contract (

t, t, t
0
) to incentivize the agent.

t (resp. t) is the transfer received by the
agent if he chooses the risky project and

S (resp. S) realizes. t
0
is the transfer he receives
if he chooses the safe project. Write the incentive constraints needed to have the risky
project being chosen if and only if is observed.
3- Write the incentive constraint needed to induce the agent to learn information.
4- Find the optimal contract oered to the agent and determine the

t, t
0
and t which
induce information learning.
5- Find the second-best rule followed by the principal.
21
Optimal Contract and Limited Liability
We consider a risk-neutral principal who delegates a task to a risk-neutral agent
protected by limited liability. His eort e is a continuous variable which costs him
(e) (

> 0,

> 0). The return to the principal q follows the distribution (F(|e)
with density f(|e) on [0, q] such that the MLRP property

f
e
(q|e)
f(q|e)

> 0
holds. The principal benets from q t(q) where t(q) is the transfers he makes to the
agent.
1- Characterize the rst-best eort.
2- Write the agents incentive and participation constraints when e is non observable by
the principal. Use the rst-order approach.
3- Write the Lagrangian of the principals problem and optimize when the transfer t(q)
belongs to [0, q]. Show that the optimal contract involves a cut-o q

such that t(q) = 0

for q < q

and t(q) = q for q > q

.
22 EXERCISES
The Value of Information under Moral Hazard
We consider the simple model of contracting with limited liability of Section 5.1.2
except that the probability of success writes as

+ e where

is a random variable with
zero mean.
1- Suppose that the agent chooses his eort before knowing the realization of

. Compute
the second-best optimal eort e
SB
.
2- Suppose that the agent wants to guarantee a probability of success R, but can ne
tune the choice of his eort as a function of the realized state of nature that he observes.
Show that

> 0 and

> 0 imply that the second best optimal eort R

SB
< e
SB
.
Conclude.
23
Raising Liability Rule
We consider a lender-borrower relationship under moral hazard. The risk-neutral
borrower wants to borrow I from a lender to nance a project with safe return V . The
project may with probability 1 e harm a third-party. The amount of safety care e costs
(e) to the borrower with (

> 0,

> 0,

> 0). The harm has value h. A nancial

contract is a pair (t,

t) where t (resp.

t) is the borrowers reimbursement to the bank if
there is no (resp. one) environmental damage.
1- Suppose that e is observable. Compute the rst-best level of safety care and assume
that the project is socially valuable when the interest rate is r.
2- Suppose now that e is not observable. We suppose that the bank is competitive and
that the borrower has sucient liability. Show that the rst-best is still implementable if
the bank must reimburse h to the third-party in case of an accident.
3- Suppose that the bank must reimburse c < h to the third-party. We denote by w the
initial assets of the borrower. Show that as w diminishes, the rst-best level of eort can
no longer be implemented.
4- Compute the second-best optimal level of eort maximizing the borrowers expected
payo subject to the banks zero prot constraint, the borrowers incentive constraint and
his limited liability constraint.
5- Show that raising the banks liability c leads to a lower expected welfare.
6- Show that this result no longer holds when the bank is a monopoly.
24 EXERCISES
Risk-Averse Principal and Moral Hazard
Suppose that a risk-averse principal delegates a task to a risk-neutral agent. With
probability e (resp. 1e) the outcome is q (resp. q < q). The risk-averse principal utility
is v(q t) where t is the agents transfer and v() is a CARA von Neumann-Morgenstern
utility function. Eort costs (e) to the agent (

> 0,

> 0).
1- Suppose that e is not observable, compute the optimal contract with a risk-neutral
agent.
2- Suppose that the agent is protected by limited liability. Compute the second-best level
of eort.
3- Analyze the two limiting cases where the principal is innitely risk-averse and where
he is risk-neutral. Explain your ndings.
25
Poverty, Health Care and Moral Hazard
We consider an economy composed of a continuum [0, 1] of identical agents. The
income of an healthy agent is w. Each agent becomes (independently) sick with probability

0
, in which case he has only a survival income of w. Let the proportion of sick agents
who benet from a medical treatment which costs m per capita: then, these agents recover
their normal income w. Finally, the utility function of an healthy agent or of a sick agent
who has received a treatment is u() with u

> 0, u

< 0. The utility function of a sick

agent who has not been treated is u
M
() with u

M
> 0, u

M
< 0.
1- Let p the insurance premium that only healthy and treated sick agents can pay. We
have potentially three types of agents:
a proportion 1
0
of healthy agents with utility level u(w p),
a proportion
0
of treated sick agents with utility level u(w p),
a proportion (1 )
0
of non treated sick agents with utility level u
M
(w).
Suppose income redistribution and price discrimination of insurance are not possible.
Write thee optimization program of a utilitarian social welfare maximizer who must satisfy
budget balance of the health sector. Write and interpret the rst order conditions of this
program with respect to and p (assume an interior solution). Determine the comparative
statics of the optimal solution with respect to m, w and
0
. Let W(
0
, p

(
0
),

(
0
))
denote optimal social welfare.
2- Suppose now that with a non observable non monetary cost of health care any agent
can decrease his probability of becoming sick from
0
to
1
, with =
0

1
.
Determine the various regimes obtained when the expected social welfare is maximized
under the budget constraint and the moral hazard constraint that agents nd valuable to
spend in order to decrease their probability of being sick.
3- We consider now pairs of agents who observe each others eort of health care, and we
assume that agents can perfectly coordinate their health care behavior. Assuming now
that everybody is treated, let t
11
the insurance premium of an healthy agent paired with
a healthy agent, t
12
(resp. t
21
) the one paid by a healthy (resp. sick) agent paired with a
sick (resp. healthy) agent and t
22
the one paid by a sick agent paired with a sick agent.
Maximize the expected social welfare of a pair of agents under the incentive constraints
that the pair prefers exerting two eorts of health care rather than zero or one and under
26 EXERCISES
an expected budget balance equation (guess that the local incentive constraint is binding
and that the other incentive constraint is satised for u(x) =

2x). Show that the

solution obtained dominates the solution with individual contracts.
27
Group Lending with Moral Hazard
We consider two entrepreneurs each of whom can carry out a project with the following
characteristics. Investing 1 generates a stochastic output which can take two values, z > 0
or 0. The probability of success (i.e., of getting z) depends in the entrepreneurs eort, e,
which can take also two values e > 0 or 0. The probability of success is p for a high level
of eort e and p for no eort with p > p > 0. The disutility of eort is for e and zero
for e = 0.
Each entrepreneur has no wealth and must borrow to invest. He can only repay his
loan if he succeeds. Denoting by x the entrepreneurs share of output, his expected utility
is
px if he exerts eort e,
px if he exerts no eort.
Funds are supplied by a prot-maximizing bank which has a cost of funds r. We
assume that:
pz > r > pz.
1- Determine the optimal contract oer to an entrepreneur when there is a single en-
trepreneur.
2- There are now two entrepreneurs who do not observe each others eort level. A
group lending contract calls for a payment x when the partner succeeds and y when it
fails. Consider a group lending contract which induces eort of both entrepreneur as a
Nash equilibrium. Show that a group lending contract does not perform better than the
individual contracts considered in question 1.
3- We suppose now that entrepreneur observe each others eort level and coordinate
their eort levels. Consider the program of the bank which implements eort by both
entrepreneurs with group lending contracts:
max p
2
(2z 2x) + p(1 p)(2z 2y) 2r
s.t.
2 p
2
x + 2 p(1 p)y 2 2p
2
x + 2p(1 p)y (1)
2p px + p(1 p)y + p(1 p)y (2)
0, (3)
28 EXERCISES
x 0, y 0.
Find the optimal contract. Show that it is better than individual contracts for the
bank. Explain why.
29
Incentives and Discovery
We consider a principal-agent relationship in which a principal delegates to an agent
the search for a resource of unknown magnitude over which the principal has property
rights.
The principals utility function is u(q) + t with u

> 0, u

< 0, u(0) = 0 and where q

is the quantity of the resource obtained by the principal and t is the monetary payment
made by the agent to the principal for being allowed to search.
The agents utility function is u( q) t.
1- Under complete information about , determine the optimal contract oered to the
agent by a principal who maximizes his utility under the participation constraint of the
agent
u( q) t 0.
2- can take one of two values {,

} with respective probabilities (1 , ), with
=

> 0 and is now private information of the agent. Suppose that the prin-
cipal oers a contract to the agent before the agents search, i.e., before the agent learns
. Characterize the optimal contract that the principal oers to the agent when he maxi-
mizes his expected utility under the agents incentive constraints and the agents ex ante
participation constraint.
3- We assume now that the contract is imperfectly enforced. When the agent discovers

(resp. ), he can exit the relationship with a quantity (resp. 0) of the resource.
Therefore, the principal is faced with the following ex post participation constraints:
u( q) t 0 (1)
u(

q)

t u(), (2)
if he wants to maintain both types of agent in the relationship.
Show that the regime with the participation constraint of the inecient type , and
the incentive constraint of the ecient type

cannot be optimal (hint: assume the
contrary).
4- Consider the regime where only the participation constraints (1) and (2) are binding
(i.e. the incentive constraints are slack). Show that this is the relevant regime when
> . Characterize the optimal contract and denote W() the principals expected
welfare.
30 EXERCISES
5- We assume now that by exerting an eort which costs him the agent increases the
probability of a

-discovery from
0
to
1
>
0
with =
1

0
. Show that W() is
decreasing in . Write the program of a principal who selects a contract which discourages
eort. Solve it when u() <

. Discussion.
31
III- MIXED MODELS
Political Economy of Regulation
We consider a rm which realizes two projects, of gross value S
1
and S
2
for the
consumers. The rm can provide an eort e
i
in order to reduce the cost associated with
project i, i = 1, 2. The cost function of the rm for project i is:
C
i
= e
i
where is the eciency parameter of the rm. The eciency of the rm is the same for
both projects.
Parameter can take values in two values {,

} with = Pr( = ).
The cost reducing eorts create a disutility to the rm equal to
(e
1
, e
2
) =
1
2
(e
2
1
+ e
2
2
) + e
1
e
2
, > 0.
A regulator reimburses the observable costs C
1
and C
2
and pays a net transfer t to
the rm which has utility
U = t (e
1
, e
2
).
Social welfare is
S
1
+ S
2
(1 + )(t + C
1
+ C
2
) + U.
1- Determine the optimal regulation under complete information.
2- Determine the optimal regulation under incomplete information when is private
information of the rm.
3- We assume now that the regulatory mechanism is determined by the political majority.
Agents are of two types. Either they are stakeholders in the regulated rm, i.e., they share
the rent of the regulated rm. Or they are non-stakeholders and do not share the rent.
Let the proportion of stakeholders. If > 1/2 the majority belongs to stakeholders
who choose regulation to maximize their objective function:
(S
1
+ S
2
(1 + )(t
1
+ C
1
+ t
2
+ C
2
)) + U.
32 EXERCISES
If < 1/2 the majority belongs to non-stakeholders who choose regulation to maximize
instead:
(1 )(S
1
+ S
2
(1 + )(t
1
+ C
1
+ t
2
+ C
2
)).
Determine in each case the optimal regulation under incomplete information.
33
Regulation of Quality
We consider a natural monopoly which has the cost function C = ( +s e)q where q
is the production level, e is the eort level of the manager, s is the quality of the product
and in {,

} is a cost parameter.
We assume that the regulator observes only the cost C and the rms revenue, and, in
addition, pays a transfer t net of cost and revenue. If (e) (with

> 0,

> 0,

0)
is the disutility of eort for the manager, it implies that the net utility of the manager is
U = t (e). His outside opportunity utility level is normalized at zero.
We assume that the consumers get a gross surplus from the consumption of q units
equal to
S(q, s, ) = (A + ks h)q
B
2
q
2

(ks h)
2
2
where A, B, h, k are positive constants and in {,

} is a demand parameter known by
the rm, but not by the regulator.
Let p(q) the inverse demand function. The utility derived by consumers is then:
V = S(q, s, ) p(q)q (1 + )(t + C p(q)q)
where 1 + is the opportunity cost of public funds.
1- We consider a utilitarian regulator who wants to maximize expected social welfare
(V + U). Show that the adverse selection problem with two parameters and can be
reduced to a one dimensional adverse selection problem with the parameter = +
h
k
.
2- Assume that is distributed according to a uniform distribution. Write the maxi-
mization problem of the regulator under the incentive and participation constraints of the
rm.
3- Show that the optimal regulation can be implemented with indirect mecanisms which
are functions of a variable which aggregates the cost and quality dimensions.
4- Study the dependence of the optimal regulatory mechanism with respect to the concern
for quality.
34 EXERCISES
Enforcement and Regulation
We consider a natural monopoly which, in addition to a xed cost F which is common
knowledge, has a variable cost function
C = ( e)q,
where q is the production level, is an adverse selection parameter in {,

} with =
Pr( = ) and e is a moral hazard variable which decreases cost, but creates to the
manager a disutility (e) with

> 0,

> 0,

0.
Consumers derive an utility S(q), S

> 0, S

< 0 from the consumption of the natural

monopolys good. Let p() the inverse demand function and

t the transfer to the rm
from the regulator. The rms net utility is:
U =

t + p(q)q ( e)q F (e).
We assume that cost is ex post observable by the regulator as well as the price and the
quantity. So, we can make the accounting assumption that revenues and cost are incurred
by the regulator, who pays a net transfer t =

t + p(q)q ( e)q F. Accordingly, the
participation constraint of the rm can be written:
U = t (e) 0.
To nance the transfer t, the government must raise taxes with a cost of public funds
1 + , > 0. Hence, consumers net utility is
V = S(q) p(q)q (1 + )

t.
Utilitarian social welfare writes then:
W = U + V = S(q) + p(q)q (1 + )(( e)q + F + (e)) U.
1- Under complete information, the regulator maximizes social welfare under the rms
participation constraint. Characterize the optimal solution.
2- Suppose now that the regulator cannot observe the eort level e and does not know
. However, he can oer a contract to the rm before the latter discovers its type (see
Figure 1 for the timing).
35
E
Time
The regulator
oers the
regulatory contract.
The rm
accepts or not
the contract.
The rm
discovers
its type.
Production
and transfer
take place.
Figure 1
Explain why the regulator can restrict his contract to a pair {(t, c); (

t, c)} (where c =
C
q
is average cost) which satisfy incentive constraints.
Write the incentive constraints and the rms ex ante participation constraint. Solve
for the optimal contracts.
3- We assume now that if the rm has a negative ex post utility (as rm

in question
3) it attempts to renegotiate its regulatory contract. However, with a probability (c),
the regulator is able to impose the implementation of the agreed upon contract. This
probability depends on the expenses c incurred to set up an enforcement mechanism.
We assume that (0) = 0,

> 0,

< 0 with the Inada conditions

(0) = and
lim
c+
(c) = 1.
With probability 1 (c) the regulator is forced to accept a renegotiation. To model
this renegotiation we use the Nash bargaining solution but assume that renegotiation is
costly (because it takes time say). The status quo payos which obtain if the negotiation
fails are determined as follows: The rm loses its xed cost F. The regulator is also
penalized by a loss of reputation and obtains the utility level H.
Assume that it is only the inecient type

which wants to renegotiate. Therefore,
costly bargaining takes place under complete information. Its outcome solves:
max
{ q, e,

U
E
}
(

U
E
+ F)(

W( q, e,

)

U
E
+ H)
where in (0, 1) models the cost of renegotiation and

W( q, e,

) = S( q) + p( q) q (1 + )((

e) q + F + ( e)).
Compute the outcome of renegotiation ( q
E
, e
E
,

U
E
).
4- Write the rms new participation constraint which takes into account that with prob-
ability 1 (c) there will be renegotiation.
Substitute the outcome of renegotiation into the regulators objective function and
solve for the optimal contract and the optimal level of enforcement expenses c. Discuss.
36 EXERCISES
Regulation of a Risk Averse Firm
We consider a utilitarian regulator who wishes to realize a public project which has
social value S. A single rm can undertake the project for a cost, C = e, where in
{,

} is an eciency parameter and e is a level of eort which creates a disutility (e)
(

> 0,

> 0,

0) for the rms manager.

The cost C is observed by the regulator who can give a transfer t to the rm with a
cost of public funds 1 + .
The manager of the rm is risk averse, and has the utility function u(t (e)) with
u

> 0, u

< 0).
e and are not observable by the regulator, but it is common knowledge that =
Pr( = ).
1- For the revelation mechanism {t(

) =

t, C(

) =

C; t() = t, C() = C}, write the
incentive and participation constraints of the rm.
2- Expected social welfare is dened as
W = S (1 + )

(t + C) + (1 )(

t +

C)

+ u
1
(u() + (1 )u( )) ,
with = t ( C) and =

t (

C).
Interpret this social welfare function and, assuming that it is concave in (, ), de-
termine the optimal regulation under incomplete information when the regulator oers a
contract at the interim stage.
3- Compare the result of question 2 with the case where the rms manager is risk neutral.
4- Consider the special case
u(x) =
1

(1 e
x
).
Show that the eort level required from type

is decreasing in .
37
Technological versus Informational Advantage
We consider a project which has value S for consumers. This project can be realized
by two dierent rms run by two dierent managers.
Firm 1 has the cost function C
1
=
1
e
1
where
1
is an eciency parameter which
is common knowledge and e
1
is the managers eort level which creates a disutility
1
4
e
2
1
for him. Ex ante
1
is unknown for everybody and drawn from {2, 3} with Pr(
1
= 2) =
Pr(
1
= 3) = 1/2.
Firm 2 has the cost function C
2
= k
2
e
2
, k 1, where
2
is also drawn ex ante
(independently of
1
) from {2, 3} with Pr(
2
= 2) = Pr(
2
= 3) = 1/2. However, the
value of
2
is only observed by the manager of rm 2; e
2
is the managers eort level
which creates a disutility
1
4
e
2
2
for him.
C
1
and C
2
are observed by the regulator. The outside opportunity utility levels are
normalized to zero for both rms. The timing of events is summarized below:
E
t
ex ante interim

1
observed
by all,
2
observed by
rm 2
Regulator
oers
contracts
Firms
accept
or
reject
Contracts
are
executed
The regulator is utilitarian and can use transfers with a price of public funds 1 + ,
> 0.
1- Assuming that the regulator oers a contract only to rm 1, at the interim stage, what
is the optimal regulation?
2- Assuming that the regulator oers only a contract to rm 2 at the interim stage, what
is the optimal regulation?
3- Assuming that the regulator selects the rm at the ex ante stage, characterize the
values of and k such that rm 2 is chosen.
4- Assuming that the regulator selects the rm at the interim stage, characterize the
values of , k and
1
such that rm 2 is chosen.
5- Suppose that k can be chosen ex ante at the cost
(1+)(3k)
2
2
by the regulator; what is
the optimal strategy of the regulator at the ex ante stage?
38 EXERCISES
Piracy and Optimal Pricing
We consider a rm which can buy from a monopoly with marginal cost c software in
quantity q
0
at price p
0
or pirate software in quantity q
c
at a random cost c which includes
the illegal reproducing cost itself and a random ne. The value for the rm of these
purchases is
R(q
0
+ q
c
) with [0, 1].
The rm has a utility function with constant absolute risk aversion so that his utility
is
e
[R(q
0
+qc)p
0
q
0
cqc]
.
1- Assuming that c is a normal random variable with mean and variance
2
, compute
the demand functions q
0
(p
0
), q
c
(p
0
) of a rm maximizing its expected utility. What is the
optimal monopoly price p
M
0
? Study the dependence of p
M
0
with respect to ,
2
, , , c.
Suppose
R(q
0
+ q
c
) = a(q
0
+ q
c
)
1
2
b(q
0
+ q
c
)
2
.
2- For a social welfare function W which adds prot to the certainty equivalent of the
consumers utility level, characterize the (constrained) optimal q
0
and q
c
. Study the
comparative statics of W with respect to , ,
2
, c (Hint: use the envelop theorem).
Let

W be social welfare under monopoly. Obtain


W

. Let = c
0
+ f where c
0
is the
reproducing cost and f an expected ne. Supposing that the cost of implementing the
ne f is
1
2
f
2
, determine the optimal ne.
3- What is the optimal two part tari of the monopolist?
4- Assume that is private information of the rm and can take two values or with
> and = Pr( = ).
We will look for the optimal nonlinear price or the optimal direct revelation mechanism
(t, q
0
,

t, q
0
). First show that the Spence-Mirrlees property holds for the surrogate utility
function:
V (t
0
, q
0
, ) = max
qc

R(q
0
+ q
c
) t
0
q
c

1
2

2
q
2
c

.
Write the rms incentive constraints for the function V . Solve for the optimal direct
revelation mechanism. Discuss.
39
Gathering information before signing a contract
We consider a principal agent problem in which the agent produces a quantity q of a
good at a cost q with in {,

},

> . Let t be the transfer from the principal to the
agent ; then, the agents utility is U = t q.
The principals utility is
V = S(q) t with S

> 0, S

< 0 and S(0) = 0.

At date 1 the principal oers a menu of contracts (t, q), (

t, q).
At date 2 the agent decides to learn at a cost or not. Let e be this decision : e = 1
if he learns, e = 0 if not. e is a moral hazard variable not observed by the principal.
At date 3 he accepts or not the contract.
At date 4 the agent learns if he has decided not to learn it at date 2.
At date 5 the contract is executed.
We will consider two sets of contracts : those (class C
1
) which induce the agent to
choose e = 0 and those (class C
2
) which induce the agent to choose e = 1.
1- Write the optimization program of a principal who maximizes his expected utility
under the incentive and participation constraints of the agent, either in the class C
1
or in
the class C
2
of contracts.
2- Show that a lower bound for the principal is obtained by constraining contracts to
t q 0 ;

t

q 0. Derive from this result that the interesting contracts to consider

entail

t

q 0. Show that the principal can always mimic a contract in the class C
2
with a contract in the class C
1
.
3- Determine the optimal contract in the class C
1
. (Distinguish three cases depending on
whether the ex ante participation constraint is binding, the moral hazard constraint is
binding or both constraints are binding according to the value of ).
40 EXERCISES
Better Information Structures and Incentives
We consider a natural monopoly which realizes a public project valued S at a cost
C = e when in {,

} is a parameter which is privately known by the manager with
=

> 0 and = Pr( = ) is the common knowledge probability that the rm is
a low cost rm; e is the managers eort which has a disutility (e) with

> 0,

> 0,

0. The cost C is observable by the regulator and reimbursed to the monopoly.

Accordingly the rms utility is
U = t (e)
where t is the net monetary transfer from the regulator to the rm and consumers welfare
is
V = S (1 + )(t + e)
where > 0 is the social cost of public funds.
Social welfare is dened as U + V .
1- Characterize the regulation which maximizes expected social welfare under the rms
incentive and participation constraints (it is assumed that the regulatory contract is of-
fered to the rm at the interim stage and that its status quo utility level is zero).
2- The regulator benets ex ante from an information structure J with a set =
{
1
,
2
, . . . ,
I
} of signals and conditional probabilities Pr(
i
|) i = 1, . . . , I. Denote

i
the posterior belief that the rm has a low cost after signal
i
, i.e.,
i
= Pr( = |
i
),
i = 1, . . . , I.
Characterize for each
i
the optimal eort level e
i
requested from the high cost rm
and denote e
i
= Z

i
1
i

the solution e
i
as a function of the ratio

i
1
i
.
Show that, if after each
i
, the regulator wants to keep both types of rms, and if Z
is concave, the expected power of incentives decreases when the regulator has access to
the information structure J.
Discuss the more general case where after some signals the regulator may want to shut
down the high cost rm.
41
Competitive Pressure and Incentives
We consider the case of a monopoly (producing good 1 in quantity q
1
) with a com-
petitive fringe producing a dierentiated good 2 in quantity q
2
. The consumers utility
function is
S(q
1
+ q
2
) + q
1
q
2
where is a measure of complementarity of the two goods.
The monopolys cost function is
C
1
= ( e)q
1
,
where in {,

},

> , is an adverse selection parameter (with = Pr( = )) and e
is an eort level which decreases cost with a disutility for the manager of (e),

> 0,

> 0,

0.
The fringes cost function is
C(q
2
) = cq
2
where c is common knowledge.
Let p
1
(q
1
, q
2
) the inverse demand function of good 1.
1- Show that for a utilitarian social welfare maximizer the social welfare function can be
written as
S(q
1
+ q
2
) + q
1
q
2
+ p
1
(q
1
, q
2
)q
1
(1 + )((e) + ( e)q
1
) cq
2
U,
where U = t (e) is the utility of the monopoly where t is the net transfer (in addition
to reimbursement of cost) from the regulator to the rm.
2- Characterize the optimal regulation under asymmetric information when the monopolys
status quo utility level is zero.
3- We say that the two goods are strategic complements (substitutes) if S

q
1
+S

+ >
0(< 0).
Show that if the two goods are strategic substitutes a reduction in marginal cost c
reduces eort for the regulated rm. If the products are strategic complements and is
large enough, then a reduction in c increases eort for the regulated rm.
4- Show that, if the two goods are strategic complements then eort of the regulated rm
decreases with an increase in the degree of substitution ( decreases). If the products are
strong enough substitutes, the eort of the regulated rm increases with the degree of
substitution.
42 EXERCISES
SOLUTIONS
I- ADVERSE SELECTION
Lending with Adverse Selection
1- It is a principal-agent problem with adverse selection. The principal is the bank and
the agent is the borrower. The agent has two possible types: Type 1 obtains h for sure for
an investment of 1. Type 2 obtains h with probability in (0, 1) and zero with probability
1 for an investment of 1. The action space is the probability granting a loan and,
when a loan is granted, the level of repayment if the project succeeds (if the project does
not succeed the borrower has no revenue and no wealth). So we have
A = {(P, r) : P [0, 1]; r IR
+
}
where P is the probability of receiving a loan and r is the repayment (in case of success).
From the Revelation Principle (Proposition 2.2), we know that we can restrict the
analysis to truthful direct revelation mechanisms, i.e., pairs {(P
1
, r
1
); (P
2
, r
2
)} which are
incentive compatible :
P
1
(h r
1
) P
2
(h r
2
) (1)
P
2
(h r
2
) P
1
(h r
1
). (2)
2- The bank maximizes its expected prot under the incentive and participation con-
straints, i.e., solves
max
{(P
1
,r
1
);(P
2
,r
2
)}
P
1
(r
1
r) + (1 )P
2
(r
2
r)
s.t. (1), (2) and
P
1
(h r
1
) u (3)
P
2
(h r
2
) u (4)
43
44 SOLUTIONS
if it wishes to give a loan with positive probability to both types (case 1). Alternatively,
it might oer a loan only accepted by type 1 (case 2).
3- Let us rst consider case 1 where the bank contracts with both types of borrowers.
Dividing (2) by , (1) and (2) imply
P
1
(h r
1
) = P
2
(h r
2
). (5)
Since is in (0, 1), (4) is binding and not (3). From (4) we have
r
2
= h
u
P
2
if P
2
= 0.
From (5) we have
r
1
= h
u
P
1
.
Substituting these expressions into the banks expected prot we get
P
1
(h r) + (1 )P
2
(h r)
u

(1 )u.
Since h > r, maximizing with respect to P
1
and P
2
gives P
1
= P
2
= 1 and r
1
= r
2
=
h
u

.
Therefore, we obtain a pooling contract with an expected prot for the bank of

h r
u

+ (1 )(h r u).
Type 1s ex post information rent is h r
1
u =
(1)

u.
Consider now case 2. The bank oers a loan intended only for type 1. It is only
constrained by type 1s participation constraint. The bank will obviously make this
constraint binding, leave no information rent to type 1, and provide a loan with probability
one:
r
1
= h u
with an expected prot for the bank (h r u).
Case 2 is better for the bank than case 1 if and only if
(h r u) >

h r
u

+ (1 )(h r u)
or
(1 )(h r u) <
(1 )

u,
i.e., the expected revenue made with type 2 borrowers is less than the expected rent which
must be given up to type 1s borrowers because of the presence of type 2 borrowers.
45
Why do we obtain a pooling contract if the principal wants both agents to participate?
The utility function of the agent can be written
U(P, r, ) = P(h r).
The Spence-Mirrlees condition writes
U

U
P
U
r

=
U

(h r)
P

= 0
and we obtain pooling because there is no way to screen apart both types. Indierences
curves of the two types in the (P, r) plan do not cross.
De Meza and Webb (1987), Stiglitz and Weiss (1981), Laont (2003).
46 SOLUTIONS
Bundling with Asymmetric Information
1- Since consumers want to consume only one unit and since only deterministic mech-
anisms are considered, there is no way to screen types with either the quantities they
consume or the probabilities of receiving the good. The seller can only post a price that
a subset of consumers accept to pay.
Given the willingnesses to pay, the three relevant prices that can be posted are ,
or + , for each good.
If p = + only 1/3 of the consumers buy and revenue is
1
3
( +). If p = ,
2
3
of the
consumers buy and revenue is
2
3
. If p = all consumers buy and revenue is .
Since < , the optimal single good price is (for each good):
p

= if 3
= if > 3
with a total revenue for both goods
R

=
4
3
if 3
= 2( ) if > 3.
2- Suppose now that the monopolist can oer a price P
B
for a bundle made of one unit
of each good. Since the willingnesses to pay for the two goods are independent, we have
six possible types of consumers with the following aggregate willingnesses to pay.
Population Preferences Aggregate willingness to pay
1
9
{ + , + } 2 + 2
2
9
{ + , } 2 +
1
9
{, } 2
2
9
{ + , } 2
2
9
{, } 2
1
9
{ , } 2 2
Again, the relevant posted prices for the bundle correspond to the willingnesses to
47
pay. It is immediate to see that
P
B
= 2 if 2
= 2 if [2, 5]
= 2 2 if 5,
with respective revenues worth
4
3
if 2
16
9

8
9
if [2, 5]
2 2 if 5.
Therefore, for in [2, 5], P
B
= 2 provides more revenue than the optimal single
good prices.
3- For the optimal prices p

we can obtain the surplus made by each type of consumer

and the associated revenue of the monopolist:
p

= p

=
Population Preferences Surplus Prot Surplus Prot
1
9
{ + , + } 2 2 4 2( )
2
9
{ + , } 2 3 2( )
1
9
{, } 0 2 2 2( )
2
9
{ + , } 2 2( )
2
9
{, } 0 2( )
1
9
{ , } 0 0 0 2( )
A successful bundle price must attract some consumers and make more prot with
them than with the optimal single good prices.
Consider the case where < 3 and p

= .
A bundle price of 2 makes positive prot since > and attracts all consumers
except the ( , ) types. It also makes more prot than the optimal single good
prices when
8
9
(2 ) >
4
9

i.e. > 2.
Adams and Yellen (1976).
48 SOLUTIONS
Incentives and Aid
1- The rich in the South solve
max
{q
R
,q
A
P
}
q
R
+ n
P
v(q
A
P
)
subject to
n
R
q
R
+ n
P
q
A
P
= n
R
y
R
hence
n
R
v

(q
A
P
) = 1, (1)
with a status quo utility level of
y
R

n
P
n
R
q
A
P
+ n
P
v(q
A
P
) = U
A
().
For v() = log(),
q
A
P
= n
R
,
U
A
() = y
R
+ n
P
(log n
R
1).
2- The rich of the South solve
max
{q
R
,q
A
P
}
q
R
+ n
P
v(q
A
P
)
n
R
q
R
+ nq
A
P
= n
R
y
R
+ n
R
a
with the same result for the consumption of the poor. Unconditional aid is ineective in
helping the poor.
The North oers now a contract (q
P
, a) which species the level of aid for a level of
consumption of the poor. It is accepted by the South as long as it gets as much as in the
autarky regime. Hence the program of the North:
max
{q
N
,q
R
,q
P
a}
q
N
+ n
P
v(q
P
)
subject to
n
R
q
R
+ n
P
q
P
= n
R
y
R
+ n
R
a
q
R
+ n
P
v(q
P
) U
A
()
49
n
N
q
N
= n
N
y
N
n
R
a
or
(n
N
+ n
R
)v

(q
P
) = 1. (2)
Comparing (1) and (2) we see that the poor in the South consume more. For v() =
log(),
q
P
= n
N
+ n
R
instead of n
R
.
3- To the previous program we must add incentive constraints. For given a and q
P
, the
richs utility is
y
R
+ a
n
P
n
R
q
P
+ n
P
v(q
P
).
The incentive constraints are
y
R
+ a
n
P
n
R
q
P
+ n
P
v(q
P
) y
R
+ a
n
P
n
R
q
P
+ n
P
v( q
P
)
y
R
+ a
n
P
n
R
q
P
+ n
P

v( q
P
) y
R
+ a
n
P
n
R
q
P
+ n
P

v(q
P
).
Since the status quo utility level U
A
() depends on the type, there is a potential
problem of countervailing incentives. However we will guess that it is, as usual, the
incentive constraint of the one who wants to lie,

, which is binding, as well as the
participation constraint of type .
The problem of the principal becomes
max
{ a, q
P
;a,q
P
}

y
N

n
R
n
N
a + n
P
v( q
P
)

+ (1 )

y
N

n
R
n
N
a + n
P
v(q
P
)

y
R
+ a
n
P
n
R
q
P
+ n
P

v( q
P
) = y
R
+ a
n
P
n
R
q
P
+ n
P

v(q
P
) (3)
y
R
+ a
n
P
n
R
q
P
+ n
P
v(q
P
) = U
A
(). (4)
Solving (3) and (4) for a and a, inserting in the objective function and maximizing
with respect to { q
P
, q
P
} yields
(n
N
+ n
R

)v

( q
P
) = 1
(n
N
+ n
R
)v

(q
P
) = 1 +

1
n
R
v

(q
P
).
Asymmetric information leads to a decrease in the poors consumption when the rich
of the South are of type , i.e., have a low altruistic behavior.
50 SOLUTIONS
With v() = log(), we get:
q
P
= n
N
+ n
R

q
P
= n
N
+ n
R


1
n
R
.
It remains to check that the participation constraint of type

is satised as well as
type s incentive constraint. Note that the above solutions are in fact only valid as long
as a 0, a 0. In fact when is too large, a = 0 and the poor in the South get the
same utility as under autarky. It happens when
n
N


1
n
R
or
n
N
n
N
+ n
R
.
Azam and Laont (2002).
51
Downsizing a Public Firm
1- Let us rewrite the constraints as

U =

t p

t p

= U p (1)
U = t p

t p =

U + p (2)

U =

t p

0 (3)
U = t p 0. (4)
Then, we are back to the familiar formulation and (2) + (3) imply (4). Now, the
good type is the -type.
2- Adding (1) and (2) implies p p. For any implementable pair (p, p), we have the
following constraints
(p p) t

t (p p)

and (3) implies

t p

.
The government minimizes the expected transfers t +(1)

t by choosing

t = p

and
t =

t + (p p) = p + p.
3- Expected social welfare can be rewritten as:
S(p + (1 ) p) (1 + )p (1 + )(1 ) p

p
up to a constant.
If we have
S

() > (1 + )

+

1
,
then, p solves
S

( + (1 ) p) = (1 + )

+

1
(5)
and p = 1.
If we have instead
(1 + )

+

1
> S

() > (1 + )
we get p = 1 and p = 0.
52 SOLUTIONS
If, nally
S

() < (1 + ),
then p solves
S

(p) = (1 + )
and p = 0.
As (5) shows, for low levels of downsizing, asymmetric information () increases the
level of downsizing and leaves it unchanged otherwise.
4- Let w the wage if the worker remains in the rm and s his severance payment if he
quits. By denition
t = pw + (1 p)s = p + p (6)

t = p w + (1 p) s = p

. (7)
A worker does not regret to have participated if his wage in the rm is larger than his
outside opportunity and his severance payment is non-negative.
Taking w = and w =

ensures the rst point. Then, from (6) and (7)
s = 0 and s =
p
1 p
> 0.
5- The incentive constraints remain unchanged so that the optimization program is now
W = S(p + (1 ) p) (1 + )p (1 + )(1 ) p

p
W
p
= [S

(1 + )]
W
p
= (1 )

(1 + )

.
As long as >

+

1+

1
, the solution is as in question 3 except that (5) must
be replaced by
S

( + (1 ) p) = (1 + )

+

1
.
When <

+

1+

1
, the rst-order conditions would call for p < p which is
in conict with the implementability condition p p. Then, we have bunching at the
optimal contract which solves
max
p
S(( + (1 ))p) (1 + )( + (1 )

)p p
53
i.e.,
S

(( + (1 ))p) =
(1 + )( + (1 )

) +
+ (1 )
.
Jeon and Laont (1999).
54 SOLUTIONS
Labor Contracts
1- The rms problem is
max
{l,t}
f(l) t subject to u(t) l 0.
So, for = :
u(t

) = l

(l

) =

u

(t

)
for =

:
u(

) =

) =

)
.
2- The rst-best allocation {(t

, l

); (

)} is not implementable. Suppose this menu were

oered under asymmetric information. Then, the worker will select (

). Indeed, his
utility is then
u(

> 0
instead of zero for (t

, l

).
Under asymmetric information, the optimal contract is the solution of
max
{(

t,

l);(t,l)}
(f(l) t) + (1 )(f(

l)

t),
subject to
u(t) l u(

t)

l
u(

t)

l 0,
where we just consider the relevant incentive and participation constraints.
Let () be the inverse function of u(), i.e., t = (u). The program can be rewritten
as:
max
{( u,

l);(u,l)}
[f(l) (u)] + (1 )[f(

l) ( u)]
u l u

l
u

l 0.
55
The two constraints are binding. Therefore u =

l and u = l +

l. Substituting
these values in the employers objective function and maximizing with respect to (l,

l)
yields
f

(l
SB
) =

u

(t
SB
)
; u(t
SB
) = l
SB
+

l
SB
f

l
SB
) =

t
SB
)
+

1

(t
SB
)
; u(

t
SB
) =

l
SB
.
Since u

(t
SB
) < u

(( l
SB
))
f

(l
SB
)u

(( l
SB
)) > = f

(l

)u

(( l

)),
which implies l
SB
< l

since u

< 0 and f

< 0.
Since
f

l
SB
) >

t)
f

l
SB
)u

((

l
SB
)) >

= f

)u

((

)),
we nally get

l
SB
<

l

.
3- The rms problem is now:
max
{t,l}
f(l) t s.t. u(t) l V
yields
u(t

) = l

+ V
f

(l

) u

(t

) = .
Under asymmetric information, the employers program is now:
max
{( u,

l);(u,l)}
(f(l) (u)) + (1 )(f(

l) ( u))
u l max(V, u

l)
u

l 0.
If

l
SB
V , the solution of question 2 is unchanged, since the rent of asymmetric
information is greater or equal to the outside opportunity level of utility.
56 SOLUTIONS
If

l
SB
< V

l

, there is no reason to distort so much the production level

of the inecient type (the -incentive constraint and both participation constraints are
binding). The rms problem becomes:
max
{( u,

l);(u,l)}
(f(l) (l + V )) + (1 )(f(

l) (

l))
V

l 0 ().
It admits the solution:
f

(l) =

u

(t)
, u(t) = l +

l
f

l) =

t)
+

1
, u(

t) =

l.
If

< V < l

, there is no reason to distort the production level of the inecient

type and the solution is characterized by (only the participation constraints are binding)
f

(l) =

u

(t)
; t = l + V
f

l) =

t)
;

t =

l.
However, if V becomes greater than l

, the

-incentive constraint is binding and
the rms problem becomes:
max
{( u,

l);(u,l)}
(f(l) (u)) + (1 )(f(

l) ( u))
u

l u

l = V l
u l = V
u

l 0.
There exists two subcases. In the rst one, the

-incentive constraint and both par-
ticipation constraints are binding.
max
{l,

l}
(f(l) (l + V )) + (1 )(f(

l) (

l + V ))
V + l 0 ()
f

l) =

t)
; u(

t) =

l
f

(l) =

u

(t)

; u(t) = l + V.
57
l is increased to reduce the information rent to zero.
Let

l
SB
be dened by
f

l
SB
) =

u

(t
SB
)

1

t
SB
)
; u(t
SB
) =

l
SB
+

l
SB
f

l
SB
) =

t
SB
)
; u(

t
SB
) =

l
SB
.
If V >

l
SB
, then only the

-incentive constraint and the -participation constraint
are binding and the solution is characterized by:
f

(l) =

u

(t)

1

t)
; u(t) = l + V
f

l) =

t)
; u(

t) =

l + V l.
58 SOLUTIONS
Control of Self-Managed Firm
1- The optimal size of the self-managed rm is the solution to
max

p
1/2
A

i.e.

LM
=

2A
p

2
.
2- The optimal allocation of labor is determined by equating the marginal product of
labor to the wage w,
1
2
p
1/2
= w or

p
2w

2
.
If w is small, the self-managed rm, which maximizes added value per capita and not
prot, restricts the size of the rm with respect to the optimal size. If w is larger than
the per capita added value for
LM
the workers of the labor managed will quit to benet
from the high wage elsewhere in the economy. From now on we assume that w is small
enough to justify the presence of the labor managed rm (LM rm).
3- The LM rm solves now
max

(p )
1/2
A

,
hence
=

2A
(p )

2
.
To achieve eciency we need to equate this term to

, i.e.
= p
4Aw
p
2
.
If instead we use a lump sum tax, the LM rm solves
max

p
1/2
A T

,
hence
=

2(A + T)
p

2
.
To achieve eciency we need
T =
p
2

2
4w
A.
59
4- Incentive constraints are
p

1/2
+

t A

1/2
+ t A

(1)
p
1/2
+ t A

1/2
+

t A

. (2)
Adding those two incentive constraints we get
p(

)(

1/2

1/2
) 0 or

.
5- The governments program is
max
{(,t);(

t)}
(p
1/2
w) + (1 )(p

1/2
w

),
subject to (1)-(2) and
p

1/2
+

t A

0 (3)
p
1/2
+ t A

0. (4)
The rms objective function is
U(, t, ) = p
1/2
A
1
t
1
.

U/
U/t

=
1
2
p
1/2
> 0,
and we could expect the usual constraints to be binding.
However, the benevolent government is only interested in eciency and would like to
implement

p
2w

2
;

2w

2
i.e.

>

. This rst-best allocation is not implementable.

Therefore, the optimal solution entails bunching and does not exploit the information
of the agent. It is obtained from the program:
max
{}
( + (1 )

) p
1/2
w,
or
=

p( + (1 )

)
2w

2
.
Here, there is a total conict between the implementability condition and the prole
of allocations that the principal is interested in.
Guesnerie and Laont (1984).
60 SOLUTIONS
Information and Incentives
1-
max
{(t,q)}
S(q) t subject to t q 0
yields
S

(q) = ; t = q.
2-
max
{(

t, q);(t,q)}
(S(q) t) + (1 )(S( q)

t)
subject to
t q

t q

q t

q
t q 0

q 0,
yields
S

(q

) = ; t = q

+ q
S

( q) =

+

1
;

t =

q.
3-
= Pr( = | = ) =

+ (1 )(1 )
= Pr( = | = ) =
(1 )
(1 ) + (1 )
.
For each value of ( and ), the optimal contract is characterized as in question 2,
where is replaced by and respectively.
4- For any , the information structure is characterized by the matrix
F =

Pr( = | = ) Pr( = | =

)
Pr( = | = ) Pr( = | =

)

or
F
1
=

1
1

.
61
For
F
2
=

1 +
1 +

.
F
1
is an improvement in the sense of Blackwell if there exists a bistochastic matrix B
such that F
2
= BF
1
.
Take
B =

1

21

21

21
1

21

.
In a classical statistical decision problem, the utility of the decision-maker increases
for an improvement of his information in the Blackwell sense. Here it is not necessarily
the case.
5- Let W() denote the expected utility of the principal (with obvious notations):
W() = Pr( = )

Pr( = | = )(S(q

) q

q(, )
+Pr( =

| = )

S( q(, )

q(, ))

+ Pr( = )

Pr( = | = )(S(q

) q

q( , )
+Pr( =

| = )

S( q( , )

q( , ))

.
This expression can be written symbolically

|
F(q, , , )dG(|)

dH().
The dierence with a classical decision problem is that F() depends here directly on
the precision of the signal and the signal , because of the presence of the information
rents q( , ) and q(, ) in the principals objective function.
Therefore
dW
d
=
W

xed in F(q,,)
. .. .
Blackwells eect
+

|
F

dG(|)dH()
. .. .
New eect
.
6- The expected utility of the principal can be rewritten
W = [S(q

) q

q(, )]
+(1 )(1 )[S( q(, ))

q(, )]
+(1 )[S(q

) q

q( , )]
+(1 )[S( q( , ))

q( , )].
62 SOLUTIONS
By the Envelop Theorem we have:
dW
d
= q(, ) (1 )[S( q(, ))

q(, )]
+ q( , ) + (1 )[S( q( , ))

q( , )]
= (1 )

q( ,)
q(,)

(q)

+

1

dq > 0,
since q( , ) > q() and S

( q( , )) >

.
63
The Bribing Game
Let (t, q) and (

t, q) the contracts oered where t (resp.

t) is the bribe requested for a
decrease of delay q (resp. q).
The principals program is
max
{(

t, q);(t,q)}

t
(q Q)
2
2

+ (1 )

t
( q Q)
2
2

subject to
q t q

t

q t
q t u
0

t u
0
.
As usual t = q + u
0
;

t =

q q + u
0
hence the solution
q = Q +

q = Q +
1

.
Agents who value more time are oered a higher decrease of delay.
This exercise ??? from Saha (2001).
64 SOLUTIONS
Regulation of Pollution
1- Let x

() the solution of
D

(x) + C
x
(x, ) = 0. (1)
If the rms must pay t(x) = D(x) + K it solves
min
x
{D(x) + C(x, ) + K}
yielding (1).
2-
max
{x,t}
{D(x) (1 + )t + t C(x, )}
subject to
t C(x, ) 0.
Let U = t C(x, ). The program can be rewritten
max{D(x) (1 + )C(x, ) U}
subject to
U 0
hence, the solution is
D

(x) + (1 + )C
x
(x, ) = 0,
t = C(x, ).
The participation constraint requires now the use of public money which has an oppor-
tunity cost of 1 +. So the marginal disutility of pollution is equal to the social marginal
cost of depollution (1 + )C
x
(x, ) which includes the nancial cost.
3- Under incomplete information the regulator maximizes expected social welfare under
the incentive and participation constraint of the rm
max
{(x,U);( x,

U)}
(D(x) (1 + )C(x, ) U) + (1 )

D( x) (1 + )C( x,

)

,
subject to
65
U

U + C( x,

) C( x, ) (2)

U U + C(x, ) C(x,

) (3)
U 0 (4)

U 0, (5)
where we use the notation U = t C(x, );

U =

t C( x,

).
As usual since C

< 0,

is the ecient type and U = 0 and

U = C(x, ) C(x,

).
Hence, the solution
D

( x) + (1 + )C
x
( x,

) = 0
D

(x) + (1 +)C
x
(x, ) +
1

[C
x
(x, ) C
x
(x,

)] = 0.
Since D

0, C
xx
> 0 and C
x
< 0, x is greater than the full information level.
Depollution is more costly because of the information rent which must be given up to
elicit the information.
4- Let U() = t() C(x(), ) the level of utility of the truthful rm when it is faced
with the DRM (t(), x()). The local incentive constraints are

U() = C

(x(), ) (6)
x() 0,
since the rst-order condition of incentive compatibility is

t() C
x
(x(), ) x() = 0
and (6) follows from the Envelope Theorem.
The second order condition is C
x
(x(), ) x() 0 or x 0 since C
x
< 0.
The regulators optimization program is
max
{x(),U()}

{D(x()) (1 + )C(x(), ) U()} dF()

subject to

U() = C

(x(), ) (())
x() 0
U() 0 for all .
Since C

< 0, the participation constraint reduces to U() 0.

66 SOLUTIONS
The Hamiltonian is
H = (D(x) (1 + )C(x, ) U)f() C

(x, ).
Since there is no constraint at =

, the transversality condition implies (

) = 0.
From the Pontryagin condition
() =
H
U
= f()
hence
(

) () = (1 F())
or
() = (1 F()).
Maximizing H with respect to x we obtain nally
D

(x()) + (1 + )C
x
(x(), )
(1 F())
f()
C
x
(x(), ) = 0.
There is no distortion at =

, and since C
x
< 0 and D

0, C
xx
> 0, an downward
distortion of pollution for all the other types.
It remains to check that the second order condition is satised, i.e., x() 0. A
sucient condition is
d
d

1 F()
f()

0 ; C
x
< 0; C
xx
0.
See Groves and Loeb (1975), Aspremont and Gerard-Varet (1979).
67
Taxation of a Monopoly
1- Because utility functions are quasi-linear all interior Pareto optima are obtained by
maximizing the utilitarian criterion under the resource constraint of the economy, i.e.,
max
{(q(),x());(q(

),x(

))}
[ log q() + x()] + (1 )[

log q(

) + x(

)]
subject to
x() + (1 )x(

) = x c[q() + (1 )q(

)] K
i.e.,
q() =

c
and q(

) =

c
.
2- A -consumers utility function writes log q + x

t where x

is a xed parameter
and t is the payment made to the monopoly. Incentive constraints are then
log q t log q

t (1)

log q

t

log q t. (2)
3- The monopolys maximization program is then
max
{(t,q);(

t, q)}
(t cq) + (1 )(

t c q)
subject to (1)-(2) and
log q t 0 (3)

log q

t 0. (4)
We can expect (3) and (2) to be binding. Hence t = log q and

t =

log q log q.
Inserting in the objective function of the monopoly and maximizing with respect to q and
q, we obtain
q =

c
; q =

c

(1 )

c
.
4- When is the tax, the monopolys problem becomes
max
{(t,q);(

t, q)}
(t cq) + (1 )(

t c q)
subject to
log q t q 0
68 SOLUTIONS

log q

t q

log q t q
where we just write the relevant constraints or
max
{q, q}

log q (c + )q

+ (1 )

log q (c + ) q log q

hence
q =

c +
; q =

c +

(1 )

c +
. (5)
Everything happens as if the marginal cost was c = c + instead of c.
The governments problem is then
max

(1 ) log q +

( log q (c + )q) + (1 )(

log q (c + ) q log q)

+(q + (1 ) q)

subject to (5).
The maximand can be rewritten
(1 )(1 ) log q + log q + (1 )

log q + ( (c + ))(q + (1 ) q).

The derivative with respect to is

(1 )(1 )
q
+

q
+ ( (c + ))

dq
d
+

(1 )

q
+ (1 )( (c + ))

d q
d
+( )(q + (1 ) q).
Using (5) this expression becomes
dq
d

(1 )
q
+

+
d q
d
(1 ) + ( )(q + (1 ) q). (6)
For > 0 and , (6) is negative for > 0. Also is bounded below by c (see
(5)). The interior solution is then:
=
( )(q + (1 ) q) +
1
q

dq
d

dq
d
+ (1 )
d q
d
< 0.
5- Let U() = log q() t() be the utility of a -consumer. By the envelope theorem,
the incentive constraints are

U() = log q() (7)

q() 0 for all . (8)
69
The monopolys maximization program is
max
{t(),q(),U()}

(t() cq())dF() =

( log q() cq() U())dF()

subject to (7)-(8) and U() 0.
The Hamiltonian is
H = ( log q() cq() U())f() + () log q().
Since U is increasing, there is no constraint at =

so that (

) = 0. From the
Pontryagin principle
() =
H
U
= f(). (9)
Integrating (9) between

and we get (

)() = F(

)F() or () = (1F()).
Maximizing with respect to q() we obtain nally

q()
= c +
1 F()
f()
1
q()
or
q
SB
() =

1F()
f()
c
with no distortion at the top only.
In the case of a uniform distribution on [2, 3], F() = 2 and c = 1:
q() = 2 3 or (q) =
3 + q
2
t() = log q()

log q(u)du
T(q) = t((q)) =

3
2
+
q
2

log q
3
2
+
q
2
2
log q(u)du
dT
dq
=
1
2
+
3
2q
+
1
2
log q
1
2
log

3
2
+
q
2

2
d
2
T
dq
2
=
3 + a
2q
2
.
T() is concave. There is a discount for buying more (see gure below).
70 SOLUTIONS
E
T

1
2
3
1 2 3

()
q
SB
()

71
Shared Information Goods, Majority Voting and Op-
timal Pricing
1- The monopolists optimization program is:
max
{q();U()}
3

2
1

q()
q()
2
2
U()

d
subject to

U() = q()
q() 0,
yielding q() = 2( 1) and an expected prot for the monopolist

I
=
3
2

2
1
[2( 1)]
2
d = 2.
2- Let G() the cumulative distribution function of the median of the types and g() its
density function. The monopolists program is:
max
{q();U()}

2
1
3

q()
q()
2
2
U()

dG()

U() = q()
q() 0,
yielding q() =
1G()
g()
and an expected prot for the monopolist

II
=
3
2

2
1

1 G()
g()

dG().
Given that G() = (5 2)( 1)
2
, we can check that q() is increasing in . Let (q)
be its inverse function. As
U() = q()
q()
2
2
t()
T(q) = t((q)) = (q)q
q
2
2

(q)
1
q(u)du.
Then each agents utility function is single-peaked, and the majority rule yields the choice
of the median agent. Indeed
V (, q) = q
q
2
2
T(q)
yields
V
qq
(, q) =

(q) < 0.
3- G() = ( 1)
2
(5 2). Then
I
= 2 and
II
9.25.
72 SOLUTIONS
Labor Contract with Adverse Selection
1- Since the observables of the principal are y and t
A = {y, t, y IR
+
and t IR} .
From the Revelation Principle, we can restrict the analysis to the pair of contracts
(y, t)( y,

t). The agents incentive constraints are

t (y)

t ( y) (1)

t (

y) t (

y). (2)
2- The principals optimization program is:
max
{(y,t),( y,

t)}
[y t] + (1 )[ y

t]
subject to (1)-(2) and
t (y) 0 (3)

t (

y) 0. (4)
We can expect the participation constraint of the inecient type (4) and the incentive
constraint of the ecient type (1) to be binding. Hence

t = (

y) and t = (y) + (

y) ( y).
Substituting these solutions in the principals objective function and maximizing with
respect to y, y we obtain:

() =

(y) =
1

) =

y) =
1

()

.
The marginal disutility of labor is equated to its marginal productivity for the ecient
type. It is distorted downwards for the inecient type. (3) is implied by (4) and (1). (2)
becomes:
0 (

y) + (y) + (

y) ( y)
or
0 y

( y)d y

(y)d
73
or
0 ( y y)

( y)d y

y
y

(y)dyd. (5)
From the optimal solution >

implies y > y hence (5) holds.
Indeed the Spence-Mirrlees condition writes here. If U = (t (y)),

U
y
U
t
=

(y)) =

< 0,
and we know from Section 2.11 that the problem is well behaved and the constraints are
binding as we guessed.
Chari (1983), Green and Kahn (1983), Hart (1983a), Hart and Holmstr om (1987).
74 SOLUTIONS
II- MORAL HAZARD
Lending with Moral Hazard
The optimization problem of the bank is:
max
x0
p(z x) r
subject to
px px (1)
px 0. (2)
The incentive constraint (1) implies x =

pp
. From (2) the expected rent of the
entrepreneur is:
R =
p
p p
.
The banks expected prot is
pz
p
p p
r.
Hence, the optimal individual contract entails a loan which induces eort if
pz + r +
p
p p
.
Otherwise, there is no lending.
75
Moral Hazard and Monitoring
1- Since p
L
= 0, it is worth nancing the project only if one can design a contract which
induces eort e
H
, satises the entrepreneurs participation constraint and ensures non
negative prot, i.e.,
p
H
(R P) B (1)
p
H
(R P) 0 (2)
p
H
P I. (3)
From (1), P = R
B
p
H
and from (3) p
H
R B + I.
2- p
H
R > I but p
H
R < B + I and m < p
H
R.
It is immediate to check that there is no pure strategy equilibrium. Let us compute the
mixed strategy equilibrium. Let
1
= Pr(e = e
H
),
2
= Pr (Monitor). The entrepreneur
must be indierent between the two eort levels, i.e.

2
p
H
(R P) + (1
2
)p
H
(R P) =
2
0 + (1
2
) B
or
p
H
(R P) = (1
2
)B.
The lender must be indierent between monitoring or not, i.e.

1
[p
H
P m] + (1
1
)(p
H
R m) =
1
p
H
P
or
m = (1
1
)p
H
R.
The participation constraint of the entrepreneur is
p
H
(R P) 0.
So the bank can now choose a best repayment of P = R. The mixed strategy equilib-
rium entails
2
= 1 and
1
= 1
m
p
H
R
. But then the eort is always high since the lender
always monitors. Lending occurs if
p
H
R m I.
76 SOLUTIONS
Inducing Information Learning
1- From Bayes rule
Pr(

S| ) =
Pr( |

S) Pr(

S)
Pr( )
=

+ (1 )(1 )
E(S| ) =


S + (1 )(1 )S
+ (1 )(1 )
=
(2 1)

S
+ (1 )(1 )
> 0
E(S|) =
(1 )

S + (1 )S
(1 ) + (1 )
=
(1 2)

S
(1 ) + (1 )
< 0.
So, the principal chooses the risky project if = and the safe project if = . His
expected utility if he decides to learn information is
(2 1)

S ,
and learning is optimal if this expression is positive.
2- The agent chooses the risky project if he learns when

t
+ (1 )(1 )
+
(1 )(1 )t
+ (1 )(1 )
t
0
. (1)
He chooses the safe project if he learns when
(1 )

t
(1 ) + (1 )
+
(1 )t
(1 ) + (1 )
t
0
. (2)
3- Ex ante, the agent decides to learn information if

t + (1 )(1 )t + [(1 ) + (1 )]t

0
t
0
(3)
t + (1 )

t. (4)
(3) (resp. (4)) says that he prefers to learn the information (and follow the optimal choices
induced by (1), (2)) rather than not learning and always choosing the safe project (resp.
not learning and always choosing the risky project).
4- But, note that (3) implies (1) and (4) implies (2). If the principal induces the agent
to learn information then the agents decision rule is optimal. Since the principal wants
to minimize payments he chooses
t = 0
t
0
=

(2 1)(1 )

t =

(2 1)(1 )
.
77
The principals expected utility is then
(2 1)

S

t [(1 ) + (1 )]t
0
= (2 1)

S

+ (1 ) + (1 )
(2 1)(1 )

. (5)
5- It is worth inducing information revelation only if (5) is positive. This happens less
often than if the principal was using the information technology himself since (5) can be
rewritten
(2 1)

S

(2 1)(1 )
.
Otherwise, he should not use the agent.
Inspired from Gromb and Martimort (2002).
78 SOLUTIONS
Optimal Contract and Limited Liability
1- The optimal contract solves the following problem
max
e

q
0
qf(q|e)dq (e)
Assuming the f() satises CDFC, we have a strictly concave objective function and
the optimal rst-best eort solves

q
0
qf
e
(q|e

)dq =

(e

).
2- The incentive constraint is

q
0
t(q)f
e
(q|e)dq =

(e), (1)
provided the agents objective function is strictly concave. It is when t

(q) > 0, and f()

satises CDFC.
The participation constraint is

q
0
t(q)f(q|e) (e) 0. (2)
3- The principals problem becomes:
max
0t(q)q

q
0
(q t(q))f(q|e)dq
subject to (1) and (2).
Writing the Lagrangian, we get:
L(q, t, e) = (q t)f(q|e) + [tf
e
(q|e)

(e)] + [tf(q|e) = (e)],

for t [0, q] where and are respectively the multipliers of (1) and (2) ( 0 because
(2) is an inequality.
The objective is linear in t and the solution has a bang-bang feature
if ( 1)f(q|e) + f
e
(q|e) > 0 then t = q
if ( 1)f(q|e) + f
e
(q|e) < 0 then t = 0
if ( 1)f(q|e) + f
e
(q|e) = 0 then t [0, q].
Note that MLRP ensures that there exists a unique q

such that
fe(q|e)
f(q|e)
>
1

for
q q

.
Hence t = q i q q

, t = 0 otherwise.
79
The Value of Information under Moral Hazard
1- The agent solves
max
e
E

+ e)

t (e)
and we get

(e) =

t.
The principal solves
max
e
e

S + (1 e)S

(e)e
which yields
S =

(e
SB
) + e
SB

(e
SB
).
2- Now the agent adjusts his eort e to have always a probability of success of R, i.e.,
e + = R or e = R .
He must be paid
E

(e)) = E

(R

))
to guarantee an eort R.
The principal solves
R

S + (1 R)S E

(E

(R

))
and the rst-order condition is
S = E

(R

) + R

(R

)).
From

> 0 and Jensens inequality, we have E

(R

))

(R) and E

(R

))

(R) hence R
SB
< e
SB
.
80 SOLUTIONS
Raising Liability Rule
1- The optimal level of eort is determined by minimizing h(1 e) + (e), i.e. by

(e

) = h. Social welfare is then

V (1 + r)I (1 e

)h (e

) > 0. (1)
2- The proper incentive for the agent is obtained by choosing

t and t such that

(e

) =

t t.
The agents participation constraint can be made binding by choosing t high enough
V (1 + r)I e

t (1 e

)t (e

) = 0.
But then the payment to the bank
e

t + (1 e

t = V (1 + r)I (e

) > (1 e

)h
is from (1) enough to pay h to the third party, when damage happens.
3- If the limited liability constraint of the borrower is binding, we have

t = w
t = w

(e

),
and the expected revenue of the bank is
w (1 e

(e

)
which must be larger than
(1 + r)I + (1 e

)c.
Clearly, as w decreases this may become impossible.
4- This contract solves
max
{e,

t,t}
V et (1 e)

t (e)
subject to

t t =

(e)

t w
e

t + (1 e)t = (1 + r)I + (1 e)c,

81
where the latter constraint is the banks zero prot condition.
This yields
max
e
V w + (1 e)

(e) (e)
subject to
w e

(e) = (1 + r)I + (1 e)c.

Therefore e is determined by the zero prot constraint
(1 e)c + e

(e) = w (1 + r)I.
5-
de
dc
=
1 e

+ e

c
< 0
for c small.
6- The banks program is then
max
{e,

t,t}
e

t + (1 e)t (1 e)c

t t =

(e)

t = w
which reduces to
max
e
w e

(e) (1 e)c
or
e

(e) +

(e) = c
with
de
dc
=
1
e

+ 2

> 0.
82 SOLUTIONS
Risk-Averse Principal and Moral Hazard
1- If the agent is risk neutral he will insure completely the principal so that:
t = q k and

t = q k
which implies

t t = q and

(e

) = q.
Finally, k is chosen to extract all the agents surplus
e

q + (1 e

)q (e

) = k.
2- If the agent is protected by limited liability we get instead the standard results,
t = 0

t =

(e).
The participation constraint of the agent is satised from the convexity of (e) since
convex and (0) 0 implies
e

(e) (e) 0.
The principal solves
max
e
e

1 exp(( q

(e)))

+ (1 e)

1 exp(q)

.
This yields the following rst-order condition
q =

(e
SB
) +
1

ln( + e
SB

(e
SB
)).
If 0,

(e
SB
) + e
SB

(e
SB
) = q as in Section 5.1.2.
If , e
SB
e

.
As the principal is more risk averse, he nds it more interesting to get more insurance
by having a constant payo across states. In the limit of an innite risk aversion, the
agents rent is no longer viewed as costly and the rst-best eort guarantees full insurance.
83
Poverty, Health Care and Moral Hazard
1- The problem of the utilitarian social welfare maximizer is
max
(p,)
(1
0
+
0
)u(w p) + (1 )
0
u
M
(w)
subject to

0
m = (1
0
+
0
)p.
Hence, the rst order conditions hold:
u(w p

) u
M
(w) = (mp

)u

(w p

) (1)

=
(1
0
)p

0
(mp

)
, (2)
(1) determines p

and (2) determines

.
Let g
1
(p) = u(w p) u
M
(w) and g
2
(p) = (mp)u

(w p).
Then g
1
() cuts only once g
2
() from above. Then, it is immediate to see that
dp

dm
< 0,
dp

dw
> 0,
dp

d
0
= 0,
and from (2)
d

dm
< 0,
d

dw
> 0,
d

d
0
< 0.
2- The problem becomes:
max
(p,)
(1
1
+
1
)u(w p) + (1 )
1
u
M
(q)
subject to

1
m = (1
1
+
1
)p (3)
(1
1
+
1
)u(w p) + (1 )
1
u
M
(w)
(1
0
+
0
)u(w p) + (1 )
0
u
M
(w). (4)
Suppose (4) is satised. Then, we obtain a solution like in 1 with
1
instead of
0
. It is
indeed the solution if (4) holds for the optimal solution p

(
1
),

(
1
), i.e., if
(1

(
1
))(u(w p

(
1
)) u
M
(w)) =

.
84 SOLUTIONS
Then, the fact that poverty prevents treating every one is enough to create the incen-
tives for health care.
For higher than

, the incentive constraint becomes binding. Substituting (3) in

(4) the optimal second best premium is such that

1
p
SB
(
1
)(1
1
)

1
(mp
SB
(
1
))

u(w p
SB
(
1
)) u
M
(w)

= ,
p
SB
(
1
) (and therefore (
1
)) decreases with .
For even higher, health care is given up.
3- Let u
11
= u(w t
11
), u
12
= u(w t
12
), u
21
= u(w t
21
), u
22
= u(w t
22
) and
() u
1
().
Maximizing expected social welfare we have:
max
u
11
,u
12
,u
21
,u
22
(1
1
)
2
u
11
+
1
(1
1
)(u
12
+ u
21
) +
2
1
u
22

subject to
(1
1
)u
11
+

2
1
1
2

(u
12
+ u
21
)
1
u
22


2
, (5)
(2
1

0
)u
11
+ (
1
+
0
1)(u
12
+ u
21
) (
1
+
0
)u
22

(6)
(1
1
)
2
(u
11
) +
1
(1
1
)((u
12
) + (u
21
)) +
2
1
(u
22
) w
1
m. (7)
Suppose that the constraint (6) is slack, and let
1
(resp.
1
) the multiplier of (5)
(resp. (7)). Then, the rst order conditions are

(u
11
) =
1

1
+

1
(1
1
)

(u
12
) =

(u
21
) =
1

1
+

1
(2
1
1)
2
1
(1
1
)
1

(u
22
) =
1

1
,
from which u
12
= u
22
, u
11
> u
22
, u
11
> u
12
and u
12
> u
22
.
Note that (6) can be rewritten
(1
1
)u
11
+
(2
1
1)
2
(u
12
+ u
21
)
1
u
22


2
+

2
(u
11
u
12
+ u
22
u
21
). (8)
Hence for (u) =
1
2
u
2
, u
11
u
12
+u
22
u
21
= 0 and the global incentive constraint is
satised.
85
In an individual contract we must solve:
max(1
1
)u
1
+
1
u
2
u
1
u
2

()
(1
1
)(u
1
) +
1
(u
2
) w
1
m (),
hence

(u
1
) =
1

+

(1
1
)

(u
2
) =
1

1
,
which is like having the constraints u
11
= u
12
and u
21
= u
22
in the previous problems.
This can only happen if
1
= 0 which is impossible when there is moral hazard.
Laont, J.J. (2003a).
86 SOLUTIONS
Group Lending with Moral Hazard
1- Since r > pz, the only potentially valuable contract is a contract which induces eort.
The bank solves the problem:
max
x0
p(z x) r
px px (1)
px 0, (2)
where (1) is the incentive constraint and (2) the participation constraint. Clearly (1)
implies (2) and is binding so that
x =

p p
and the banks expected prot is
pz
p
p p
r. (3)
If (3) is negative, then there is no lending. So, because the bank maximizes prot, it
may not lend, when it is socially valuable to lend. We may indeed have
pz
p
p p
r < 0 < pz r.
2- Eort provision is a Nash Equilibrium if
p( px + (1 p)y) p( px + (1 p)y). (4)
The banks expected prot per entrepreneur is
p(z ( px + (1 p)y)) r.
From (4)
px + (1 p)y

p p
;
hence
p(z ( px + (1 p)y)) r pz r p

p p
.
3- Constraint (3) in the text is implied by (1). Suppose that the local incentive constraint
is not binding. It can be rewritten:
p
2
x + p(1 p)y p
2
x + p(1 p)y.
87
The banks expected prot is
2 p(z ( px + (1 p)y)) 2r.
The solution of the maximizations bank under constraint (1) is x =

p
2
p
2
, y = 0, i.e.,
the entrepreneurs are rewarded only if they both succeed. It remains to check that (2) is
satised by this solution, i.e.:
2( p
2
p p)

p
2
p
2

2
p
p + p
1 or p p
which holds.
The banks expected prot per entrepreneur is
pz r
p
2

p
2
p
2
= pz r
p
p + p

p
p p
greater than the expected projet in the optimal individual contract
pz r
p
p p
.
Group lending dominates. Under group lending, agents coordinate their choices of
eort. When considering a deviation to zero eort, an agent takes into account the
negative externality he exerts on the other since such a deviation makes it less likely that
the other agent receive a reward. Incentives provision is easier with group lending.
Laont, J.J. and P. Rey (2003b).
88 SOLUTIONS
Incentives and Discovery
1- The principal solves
max u(q) + t
subject to
u( q) t 0,
hence the solution q =

2
and t = u

.
2- The principal solves
max
{( q,

t);(q,t)}
(u( q) +

t) + (1 )(u(q) + t),
subject to

U = u(

q)

t u(

q) t
U = u( q) t u( q)

t
(u(

q)

t) + (1 )(u( q) t) 0.
From Chapter 2, we know that, under ex ante contracting with a risk-neutral agent,
the principal achieves the rst best
q =

2
; q =

2
,
and that there are many pairs of transfers (t,

t) or rents (U,

U) which implement this
allocation.
3- Suppose on the contrary that the usual constraints, i.e., the

-incentive constraint
and -participation constraint are binding. Then:
U = u( q) t = 0

U = u(

q)

t = u(

q) t
= u( q) t + u(

q) u( q)
= u( + q) u( q).
When those constraints are binding, the optimization of the principal yields immedi-
ately:
u

(q) = u

( q) +

1

( q) u

q)

.
89
Since u

< 0, u

( q) > u

q), hence u

(q) > u

( q) hence q < q or q <

2
.
Therefore q < and

U = u( + q) u( q) < u() u(0) = u(),

so that the

ex post participation constraint (2) is not satised, a contradiction with the
assumption that the optimal contract entails the postulated binding constraints.
4- If only the participation constraints are binding
t = u( q);

t = u(

q) u().
The optimal solution entails
q =

2
and q =

2
.
These are the relevant constraints when > . Indeed, let us check that the incentive
constraints are then slack
u

t = u() > u

+

2

,
from the concavity of u():
u

t = 0 > u() u

,
since
u

> u(0) > u().

The principals expected welfare is
W() = 2

+ (1 )u

u().
5- Note that for = or

= 2
dW
d
() = 2

u() u

u()
= u() 2u

< 0.
Note that
d
d

dW
d

=
d
d

u()

= u

() < 0,
90 SOLUTIONS
i

2
< or

> 2 or > .
So
dW
d
() < 0 for all

such that > .
Since W is decreasing in , the principal does not wish to encourage eort but in the
contrary to discourage eort. He solves the program:
max
(q, q,t,

t)

0
(u( q)

t) + (1
0
)(u( q)

t),
subject to
u( q) t 0 (1)
u(

q)

t u() (2)

0
(u(

q)

t) + (1
0
)(u( q) t)
1
(u(

q)

t) + (1
1
)(u( q) t) . (3)
With (1) is binding, (2) and (3) become
u(

q)

t max

u(),

,
or, since u() <

t = u(

q) +

and t = u( q).
Therefore, eort is discouraged with the ecient sharing of resources q =

2
, q =

2
.
Laont, J.J. (2003c).
91
III- MIXED MODELS
Political Economy of Regulation
1-
max
{t,C
1
,C
2
,e
1
,e
2
}
W = S
1
+ S
2
(1 + )(t + C
1
+ C
2
) + U
subject to
t

1
2
(e
2
1
+ e
2
2
) + e
1
e
2

0
C
i
= e
i
i = 1, 2,
hence
e
1
= e
2
=
1
1 +
.
2- Let U = t (e
1
, e
2
) = t ( C
1
, C
2
).
The incentive constraints are

U =

t (

C
1
,



C
2
) t (

C
1
,

C
2
)
U = t ( C
1
, C
2
)

t (

C
1
,

C
2
),
or

U U (C
1
, C
2
) (1)
U

U + (

C
1
,

C
2
), (2)
with (C
1
, C
2
) = (

C
1
,

C
2
) ( C
1
, C
2
).
The participation constraints are

U 0 (3)
U 0. (4)
Expected welfare can be written
EW = S
1
+ S
2
(1 + )

(1 )

C
1
,



C
2
) +

C
1
+

C
2

+(( C
1
, C
2
) + C
1
+ C
2
)

(U + (1 )

U).
92 SOLUTIONS
Assuming that (2) and (3) are binding and optimizing we nd
e
1
= e
2
=
1
1 +
e
1
= e
2
=
1
1 +


1 +

1
.
3- For a majority of non-shareholders we nd
e
1
= e
2
=
1
1 +
e
1
= e
2
=
1
1 +
.
For a majority of shareholders we nd
e
1
= e
2
=
1
1 +
e
1
= e
2
=
1
1 +

(1 + ) 1
(1 + )

1
.
So a majority of non-stakeholders (stakeholders) distorts downward too much (too
little) eort, because they undervalue (overvalue) rents with respect to the maximization
of social welfare. This democratic uctuation of policies is detrimental and opens the
possibility that decentralization of the regulation of each project in each region could
dominate this centralized regulation.
Laont and Pouyet (2003).
93
Regulation of Quality
For the solution see Laont and Tirole (1993), Chapter 4.
94 SOLUTIONS
Enforcement and Regulation
1- The regulator solves
max
(q,e,U)
S(q) + p(q)q (1 + )(( e)q + F + (e)) U
subject to
U = t (e) 0.
The solution is
S

(q

) + (p

(q

)q

+ p(q

)) = (1 + )( e

(e

) = q

U = 0.
2- From the Revelation Principle we can restrict the analysis to the pair {(t, c); (

t, c)}. It
is incentive compatible if
U = t ( c)

t ( c)

U =

t (

c) t (

c).
The rms ex ante participation constraint is
U + (1 )

U 0.
From Chapter 2 we know that eciency is achieved for adverse selection problems and
ex ante participation constraints when the agent is risk neutral. There are many transfers
(or rents) which implement the ecient allocation.
3- The outcome of renegotiation entails ecient levels of production q

and eort e

since
renegotiation takes place under complete information when =

, and the rms rent
level

U
E
=


W( q

, e

,

) + H
2

F
2
.
4- The rms new participation constraint is
U + (1 )(c)

U + (1 )(1 (c))

U
E
0.
95
The regulator solves now:
max
(q,e, q, e,c)
[

W(q, e, ) U] + (1 )(c)[

W( q, e,

)

U]
+(1 )(1 (c))[W( q

, e

,

)

U
E
] (1 + )c,
under the participation and incentive constraints. We obtain immediately
q
E
= q

e
E
= e

q
E
= q

e
E
= e

(1 )

(c
E
) =
1 +
(1 )

W( q

, e

,

)
.
Laont, J.J. (2002).
96 SOLUTIONS
Regulation of a Risk Averse Firm
1- The participation constraints are
u(

t (

C)) 0
u(t ( C)) 0.
The incentive constraints are
u(

t (

C)) u(t (

C))
u(t ( C)) u(

t (

C)).
Since u

> 0 and u(0) = 0 they reduce to

=

t (

C) 0 (1)
= t ( C) 0 (2)

t (

C) t (

C) (3)
t ( C)

t (

C). (4)
2- Social welfare adds the utility of consumers when they pay for the cost (t + C) from
distortionary taxes with a social cost of public funds 1 + , and the certainty equivalent
of the managers welfare.
As usual (1) and (4) are the relevant constraints and they can be rewritten
0 (5)
+ (

C) (

C)
. .. .
H(

C)
(6)
The regulators optimization program reduces to
max
{C,

C,, }
S (1 + )

( + ( C) + C) + (1 )( + (

C) +

C

+u
1
(u() + (1 )u( ))
subject to (5)-(6)
or
max
{C,

C}
S (1 + )

(H(

C) + ( C) + C) + (1 )((

C) +

C)

97
+u
1
(u(H(

C))),
hence

(e) = 1

( e) = 1 +

1
H

(

C)
u

(H(

C))H

(

C)
(1 )(1 + )u

(u
1
(u(H(

C)))
3- When the rm is risk neutral, u(x) = x. Then u

(c

) = 1,

(e) = 1

( e) = 1 +

1
H

(

C)
H

(

C)
(1 )(1 + )
u(H(

C)) > u(H(

C)) implies H(

C) > u
1
(u(H(

C))) or u

(H(

C)) < u

(u
1
(u(H(

C)))).
Thus,

() > 0 implies e is smaller when the rm is risk-neutral.

4-
u(x) =
1

(1 e
x
)
u

(H) = e
H

( e) = 1 +

1

1
e
H
(1 + )(1 (1 e
H(

C)
))

.
If = 0

( e) = 1 +

1 +

1
H

(

C)
= 1

1 +

( e).
As increases, e decreases if
e
H
(1(1e
H(

C)
))
decreases with (since H

< 0).
But this expression is equal to
1
(1 )e
H(

C)
+
which is a decreasing function of .
So eort decreases as risk aversion increases. Indeed, the regulator perceives more neg-
atively the randomness of the rms rents and decreases eort to decrease the information
rent.
98 SOLUTIONS
Technological versus Informational Advantage
1- Optimal regulation for rm 1:
max
(t
1
,C
1
)
S (1 + )(t
1
+ C
1
) +

t
1

e
2
1
4

subject to
(PC) t
1

e
2
1
4
0.
t
1
is costly, therefore, PC will bind. Substituting PC into the objective function, the
problem becomes:
max
e
1
S (1 + )

e
2
1
4
+
1
e
1

FOC with respect to e

1
: (1 + ) (1 + )
e

1
2
= 0
e

1
= 2. (1)
If
1
= 2, then
C
1
= 2 e

1
= 0
t
1
=
e
2
1
4
= 1.
If
1
= 3, then
C
1
= 3 e

1
= 1
t
1
=
e
2
1
4
= 1. (2)
Ex ante welfare (expected) is:
W
1
=
1
2
[S 1] +
1
2
(S (1 + ) 1)
or
W
1
= S
3
2
(1 + ). (3)
2- Optimal contract for rm 2. Regulator solves:
max
{ e
2
,e
2
}
1
2

S (1 + )(

t
2
+ 3k e
2
) +

t
2

e
2
2
4

+
1
2

S (1 + )(t
2
+ 3k e
2
) +

t
2

e
2
2
4

.
99
subject to
t
2

e
2
2
4
0 (PC)

t
2

e
2
2
4
0 (PC)

t
2

e
2
2
4
t
2

(e
2
+ k)
2
4
(IC)
t
2

e
2
2
4


t
2

( e
2
k)
2
4
(IC).
(PC) and (IC) bind so that

t
2
=
e
2
2
4
t
2
=
e
2
2
4
+
e
2
2
4

( e
2
k)
2
4
.
Substituting into the objective function and maximizing with respect to e
2
, e
2
, we
obtain e
2
= 2, e
2
= 2

1+
k and

t
2
= 1

1 +
k +

2
4(1 + )
2
k
2
. (4)
t
2
= 1 + k
6 + 2
8(1 + )
k
2
. (5)

C
2
= 3k e
2
=
(3 + 4)k
(1 + )
2
C
2
= 2k e
2
= 2k 2. (6)
Substituting (4), (5) and (6) gives us the expected social welfare:
W
2
=
1
2

(1 + 2)
4(1 + )
k
2
(5 + 6)k

+ [S + (1 + )]. (7)
3- Condition on and k for selection of rm 2. From (7) and (3):
(W
2
W
1
) 0
(1 + 2)
8(1 + )
k
2

(5 + 6)
2
k +
5
2
(1 + ) 0. (8)
k = 0 W
2
W
1
=
5
2
(1 + ) > 0
k = 1 W
2
W
1
=
(1 + 2)
8(1 + )

5 + 6
2
+
5
2
(1 + )
=
(1 + 2)
8(1 + )


2
< 0 (for > 0).
100 SOLUTIONS
Also,
d
dk
(W
2
W
1
) =
(1 + 2)
4(1 + )
k
5 + 6
2
< 0 for any k in [0, 1].
Since (W
2
W
1
) is decreasing over the entire range k in [0, 1] and (W
2
W
1
) > 0 for
k = 0 and (W
2
W
1
) < 0 for k = 1 the smaller of the two roots of the quadratic equation
(8) gives the value of k, below which rm 2 is preferred, i.e.,
k <

5+6
2

26
2
+55+25
4
2
(1+2)
8(1+)
(9)
then choose rm 2.
4- Choosing rm in the interim stage. If the choice is made in the interim stage, W
1
is
either
W
1
= S (1 + )(t
1
+ C
1
)
if
1
= 2, or
W
1
= S (1 + )(

t
1
+

C
1
)
if
1
= 3.
From above: If

1
= 2, t
1
= 1, C
1
= 0 W
1
= S (1 + )

1
= 3,

t
1
= 1,

C
1
= 1 W
1
= S 2(1 + ).
Case 1:
1
= 2
W
2
W
1
=
(1 + 2)
8(1 + )
k
2

(5 + 6)
2
k + 2(1 + ) (10)
k = 0 (W
2
W
1
) > 0
k = 1 (W
2
W
1
) < 0
d
dk
(W
2
W
1
) =
(1 + 2)
4(1 + )
k

5 + 6
2

< 0 for any k in (0, 1).

The smaller root of the quadratic equation is
R
1
=
5+6
2

28
2
+56+25
4
2
(1+2)
8(1+)
. (11)
101
If k < R
1
, then choose rm 2 at the interim stage when
1
= 2 for rm 1.
Case 2:
1
= 3.
Can be done in a similar manner as Case 1.
5- For any k, W
2
is now given by
W
2
=
1
2

(1 + 2)
4(1 + )
k
2
(5 + 6)k

+ [S + (1 + )]
(1 + )(3 k)
2
2
from (7).
So the optimal k will now be given by:
max
k
W
2

(1 + )(3 k)
2
2
gives
k

=
2(1 + )
7 + 2
2
+ 4
. (12)
The optimal strategy depends upon comparing W
2
with W
1
:
W
2
W
1
=
1
2

(1 + 2)
4(1 + )
k
2
(5 + 6)k

+[S+(1+)]
(1 + )(3 k)
2

S
3
2
(1 + )

.
or
W
2
W
1
=

2
2
7 4
8(1 + )

k
2
+
1
2
k 2(1 + ) < 0 for any k in (0, 1).
Therefore, the optimal strategy is to always choose rm 1.
Note that W
1
does not depend on k, so any k in (0, 1) is optimal.
102 SOLUTIONS
Piracy and Optimal Pricing
1-
max
(q
0
,qc)
E

e
(R(q
0
+qc)p
0
q
0
cqc

is equivalent to
max
(q
0
,qc)
e
[R(q
0
+qc)p
0
q
0
qc
1
2
q
2
c

2
]
or
R

(q
0
+ q
c
) = p
0
R

(q
0
+ q
c
) = + q
c

2
q
c
(p
0
) =
p
0

2
. (1)
Since R(q
0
+ q
c
) = a(q
0
+ q
c
)
1
2
b(q
0
+ q
2
)
2
a b(q
0
+ q
c
) = p
0
q
0
(p
0
) =
a p
0
b

(p
0
)

2
(2)
=
a
2
+ b
b
2

p
0
b
2
(
2
+
2
).
The monopoly maximizes (p
0
c)q
0
(p
0
), i.e.
(p
0
c)
dq
0
dp
0
+ q
0
(p
0
) = 0
p
M
0
=
1
2

a
2
+ b

2
+
2
b
+ c

. (3)
p
M
0

=
1
2

2
+
2
b

> 0
p
M
0
c
=
1
2
> 0
p
M
0

=
1
2

2
b( 2a) 2
2
b
2
(
2
+
2
b)
2

p
M
0

2
=
1
2

(
2
+
2
b)a (a
2
+ b)
(
2
+
2
b)
2

103
p
M
0

2
=
b(a )
(
2
+
2
b)
2
> 0 if a >
< 0 if a < .
p
M
0

=
b
2
(a )
(
2
+
2
b)
2
< 0 if a >
< 0 if a < .
2- W = (p
0
c)q
0
+ R(q
0
+ q
c
) p
0
q
0
q
c

1
2
q
2
c

2
.
The optimal levels of q
0
and q
c
are obtained by maximizing W with respect to q
0
and
q
c
. By the Envelope Theorem
W

= q
c
R

(q
0
+ q
c
) > 0
W

= q
c
< 0
W

2
=
1
2
q
2
c
W
c
= q
0
< 0.
Welfare under monopoly is:

W = (p
M
0
c)q
M
0
+ a(q
M
0
+ q
M
c
)
1
2
b(q
M
0
+ q
M
c
)
2
p
M
0
q
M
0
q
M
c

1
2

2
(q
M
c
)
2
.
where q
M
0
, q
M
c
and p
M
0
are given by equations (2), (1) and (3) respectively. From the
envelop theorem

= (p
M
0
c)
q
M
0

q
M
0
p
0

q
M
c
. (4)
From (2) and (3):
q
M
0

2
p
M
0

=
1
2

2
+
2
b

.
Substituting in (4):

4
2
+ 3
2
b
4(
2
+
2
b)

2

[3(
2
+
2
b)c + a
2
]
4(
2
)(
2
+
2
b)
. (5)
104 SOLUTIONS
Given that = c
0
+ f,

=


W
f
.
The optimal ne is given by:
max
f

W
1
2
f
2

,
hence:

W
f
f = 0
or

4
2
+ 3
2
b
4
2
(
2
+
2
b)

. .. .
||
A
f + Ac
0
B f = 0
where
B =

3(
2
+
2
b)c + a
2
4
2
(
2
+
2
b)

or
f = max

Ac
0
+ B
A
, 0

(6)
3- Two part tari (p
0
, F)
max
p
0
,A
(p
0
c)q
0
+ F
subject to
R(q
0
+ q
c
) p
0
q
0
q
c

2
q
2
c
2
F 0 (PC).
Hence
q
0
=
a p
0
b

(p
0
)

2
q
c
=
p
0

2
.
The participation constraint will bind (because raising F is desirable for the monop-
olist). Therefore:
F = a(q
0
+ q
c
)
b
2
(q
0
+ q
c
)
2
p
0
q
0
q
c

2
q
2
c
2
. (7)
Substituting F, q
0
and q
c
in the objective function, the problem becomes
max
p
0
cq
0
+ a

a p
0
b

1
2
b

a p
0
b

p
0

2
2

p
0

2
105
p
0
= c. (8)
4- Substituting p
0
= c in the expression for q
0
, q
c
and (7) gives us the lumpsum payment
F.
Let us now show that the Spence-Mirrlees property holds:
V (t
0
, q
0
, ) = max
qc

R(q
0
+ q
c
) t
0
q
c

1
2

2
q
2
c

.
Hence the F.O.C.: (a b(q
0
+ q
c
))
2
q
c
= 0
q
c
=
(a bq
0
)
b
2
+
2
(9)
or
V (t
0
, q
0
, ) = a

q
0
+

2
(a bq
0
)
b
2
+
2

b
2

q
0
+

2
(a bq
0
)
b
2
+
2

2
t
0

(a bq
0
)
2
b
2
+
2

1
2

(a bq
0
)
b
2
+
2

2
V
t
0
= 1
V
q
0
= a b(q
0
+ q
c
) = a bq
0
b

2
(a bq
0
)
b
2
+
2

V/q
0
V/t
0

=
2
b(
2
(a bq
0
) )
(b
2
+
2
)
2
< 0.
V (t
0
, q
0
; ) = aq
0

1
2
bq
2
0
+
1
2

((a bq
0
) )
2
b
2
+
2

t
0
. (10)
The monopolists problem is:
max
{(q
0
, q
0
),(t
0
,

t
0
)}
[t
0
cq
0
] + (1 )[

t
0
c q
0
]
subject to
V (

t
0
, q
0
, ) 0 (PC)
V (t
0
, q
0
, ) 0 (PC)
V (

t
0
, q
0
, ) V (t
0
, q
0
, ) (IC)
V (t
0
, q
0
, ) V (

t
0
, q
0
, ) (IC).
106 SOLUTIONS
(PC) and (IC) will bind. Using (10) and this fact we get:

t
0
= a q
0

1
2
b q
2
0
+
1
2
((a b q
0
) )
2
b
2
+
2
, (11)
and
t
0
= aq
0

1
2
bq
2
0
+
1
2

((a bq
0
) )
2
b
2
+
2

1
2
[(a b q
0
) ]
2

2
(b
2
+
2
)(b
2
+
2
)
. (12)
Substituting (11) and (12) in the objective function and maximizing w.r.t. q
0
and q
0
we get:
q
0
: a bq
0
+
(b)
b
2
+
2
[(a bq
0
) ] c = 0
q
0
: +
(E)
. .. .

(a b q
0
)
(b
2
+
2
)(b
2
+
2
)

(b)
2
+(1 )

a b q
0

b
b
2
+
2
[(a b q
0
) ]

c
. .. .
(D)
= 0
q
0
is the same as under complete information case and q
0
is greater than that under
the complete information case, i.e., there is an upward distortion in the quantity sold to
the low type. (If the problem is concave, D will be a decreasing function of q
0
and since
E is positive we need q
0
to be greater than that under complete information case for the
above FOC to hold).
Crampes, C. and J.J. Laont (2002)
107
Gathering Information before Signing a Contract
1- If the agent learns he accepts the contract only if t q is non-negative. His expected
utility is then
max(0, t q) + (1 ) max(0,

q) .
Accordingly the moral hazard constraint inducing no eort in gathering information
is
(t q) + (1 )(

q) max(0, t q) + (1 ) max(0,

q) . (1)
The optimization problems of the principal are formalized as shown below in the
solution of question 2.
2- Consider a contract in the class C
2
. Since

t

q < 0 the agent accepts only the contract

if = . The principal can mimic this contract by choosing

t = q = 0 and the agent saves
the information cost.
So the principal can always mimic a contract in the class C
2
with a contract in the
class C
1
.
If t q 0 and

t

q 0, (1) is strictly satised. The principal must then solve the

classical problem
max
{( q,

t);(q,t)}
(S(q) t) + (1 )(S( q)

t)
subject to
t q

t q (2)

q t

q (3)
t q 0 (4)

q 0, (5)
which yields the second-best solution
S

(q
SB
) = ; S

( q
SB
) =

+

1

t = q
SB
+ q
SB
;

t =

q
SB
.
The principals utility level is V
SB
, which can be improved by lowering the e and e in
the same amount . It is easy to check the new contract still belong to C
1
.
108 SOLUTIONS
This solution is the one obtained when the agent is informed costlessly. So it cannot
be dominated by a solution in which the agent is informed at the cost .
From the incentive constraint (2), tq 0 if

t

q 0. So, the only other interesting

case to consider is t q > 0;

t

q < 0.
The moral hazard constraint becomes
(1 )(

q) .
The general optimization problem in the class C
1
is
max
{(q,t);( q,

t)}
(S(q) t) + (1 )(S( q)

t)
subject to
t q

t q incentive constraint (6)

q t

q incentive constraint (7)

(t q) + (1 )(

q) 0 participation constraint (8)

(t q) + (1 )(

q) max(0, t q) + (1 ) max(0,

q) (9)
moral hazard constraint.
For the maximization in the class C
2
, (8) and (9) are replaced by
max(0, t q) + (1 ) max(0,

q) 0 (10)
max(0, t q) + (1 ) max(0,

q) 0. (11)
The maximimand in the class C
2
is (S(q) t).
3- Let us come back to the maximization in the class C
1
, with (9) replaced by (1 )(

q) . If (8) is binding and not (9), we have a classical problem with an ex ante
participation constraint. We know that the principal can reach the rst best S

(q
FB
) = ;
S

( q
FB
) =

with a zero expected rent
(t q
FB
) + (1 )(

q
FB
) = 0.
This case is valid if (9) is not binding, i.e., if
(1 )(

q
FB
) . (12)
109
The highest value of

t

q is obtained when the incentive constraint (6) is binding

t q
FB
=

t q
FB
hence from (8)

q
FB
= q
FB
.
Then (12) becomes (1 ) q
FB
.
If (9) is binding and not (8)

t =

q

1
and from the incentive constraint
t = q + q

1
.
The optimal quantities are the second-best ones and the welfare of the principal is
V
SB
+

1
.
This solution is valid if (4) is satised

q

1

+ (1 )

> 0
or
(1 ) q
SB
.
Finally, when (8) (9) are binding as well as (6) we obtain S

(q) = and
q =

(1 )
.
Summarizing we have:
E
T
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2

q
FB
q
SB
(1 ) q
SB
(1 ) q
FB
The principal suers from the ability of the agent to become informed about its type
before contracting. If = 0 it is as if contracting was at the interim stage. When
110 SOLUTIONS
is large enough the principal can achieve the rst-best and as increase the principals
utility increases between V
SB
and V
FB
.
Cremer and Khalil (1992), Demski and Sappington (1986), Sappington (1984).
111
Better Information Structures and Incentives
1- Social welfare is
W = S (1 + )(t + e) + U = S (1 + )((e) + e) U.
The regulators program is
max
{(e,U);( e,

U)}

S (1 + )( e + (e)) U

+(1)

S (1 + )(

e + ( e))

subject to
U

U + ( e)

U U (e + )
U 0

U 0,
with (e) = (e) (e ).
Hence, the solution is:

(e) = 1 ;

( e()) = 1

1 +

( e())
U = ( e) ;

U = 0.
Furthermore there is shutdown of the inecient rm (with U = 0) if

dened
as the solution of
(1

S (1 + )

e(

) + ( e(

))

( e(

)).
2- The same analysis as in 1 can be made for each signal
i
with the posterior probabilities

i
instead of , hence, for each i

(e
i
) = 1

( e
i
) = 1

1 +


i
1
i

( e
i
). (1)
Let e
i
(
i
) = Z

i
1
i

the solution of (1).

When the regulator keeps both types of rms
E

i

i
= E

i
E(1I
{}
|
i
) = E1I
{

}
=
112 SOLUTIONS
where 1I
{}
= 1 if = , 1I
{}
= 0 if =

, by the low of iterated expectations.
From Jensens inequality
E

i
e
i
(
i
) e() if

Z(
i
) Z

i
1
i

,
is concave.
Since

> 0,

> 0, Z() is a decreasing function. h(

i
)

i
1
i

is an increasing
convex function. Hence

Z

= Z

2
+ Z

. Therefore

Z is concave if Z

0. Note that

Z is concave if is quadratic or small enough.

So, the expected power of incentives decreases if the regulator has access to the infor-
mation structure I and there is never shutdown after
i
, i = 1, . . . , I.
Say that a signal is favorable (defavorable) if
i
> (
i
< ). Then incentives decrease
(increase) for a favorable (defavorable) signal.
Now, if after each favorable signal

i
>

, i.e., the regulator shuts down the inecient

rm, the incentives increase (since

(e
i
) = 1) when the rm is active. Since, on the
other hand incentives increase when the signal is unfavorable, incentives increase with the
availability of the information structure.
Boyer and Laont (2003).
113
Competitive Pressure and Incentives
1- Consumers utility is
V = S(q
1
+ q
2
) + q
1
q
2
p
1
(q
1
, q
2
)q
1
p
2
(q
1
, q
2
)q
2
(1 + )

t
where

t is the gross transfer to the rm.
The monopolys utility is
U =

t + p
1
(q
1
, q
2
)q
1
( e)q
1
(e) t (e).
The fringes utility is
U
F
= p
2
(q
1
, q
2
)q
2
cq
2
.
Social welfare is
V + U + U
F
= S(q
1
+ q
2
) + q
1
q
2
+ p
1
(q
1
, q
2
)q
1
(1 + )(( e)q
1
+ (e)) cq
2
U.
2- Optimal regulation is characterized by the solution of
max

S(q
1
+ q
2
) + q
1
q
2
+ p
1
(q
1
, q
2
)q
1
(1 + )(( e)q
1
+ (e)) cq
2
U

+(1 )

S( q
1
+ q
2
) + q
1
q
2
+ p
1
( q
1
, q
2
) q
2
(1 + )((

e) q
2
+ ( e)) c q
2

subject to
U

U + ( e)
U

U (e + )
U 0

U 0,
with ( e) = ( e) ( e ). Hence the rst-order conditions

(e) = q
1

( e) = q
1

1 +

( e)
S

+ q
2
+

p
1
q
1
(q
1
, q
2
)q
1
+ p
1
(q
1
, q
2
)

= (1 + )( e)
S

+ q
1
+
p
1
q
2
(q
1
, q
2
)q
1
= c

+ q
2
+

p
1
q
1
( q
1
, q
2
) q
1
+ p
1
( q
1
, q
2
)

= (1 + )(

e)

+ q
1
+
p
1
q
2
( q
1
, q
2
) q
1
= c.
114 SOLUTIONS
3- We have two sets of 3 equations (one for = and one for =

). Dierentiating
these systems we have with the determinant D < 0, for both types
de
dc
=
1
D

+ +

2
p
1
q
1
q
2
q
1
+
p
1
q
2

Sign

de
dc

= Sign (S

+ + (S

q
1
+ S

+ )).
If goods are strategic substitutes (S

q
1
+ S

+ ) < 0 then
de
dc
> 0.
If goods are strategic complement (S

q
1
+ S

+ ) > 0 and is large enough

de
dc
< 0.
4- For both types we have
de
d
=
1
D

q
1

+ +

2
p
1
q
1
q
2
q
1
+
p
1
q
2

+ q
2

2
p
1
q
2
2
q
1

,
S

2
p
1
q
2
2
q
1
is negative from the second-order condition.
If goods are strategic complements

+ +

2
p
1
q
1
q
2
q
1
+
p
1
q
2

> 0,
then
de
d
> 0.
If they are strategic substitutes, the substitution eect may dominate and
de
d
< 0.
Boyer and Laont ( 2003).