Designing Contracts Under Hidden Information: Sukanta Bhattacharya

Designing Contracts under Hidden Information
Sukanta Bhattacharya
Sep-Dec 2019
Sukanta Game Theory 9 November, 2019 1 / 46

What is a contract
A contract is an agreement that supports exchange between supplier

(seller) and demander (buyer).
Standard microeconomics: Supply = Demand is just the Nash
equilibrium of a game where no-one’s decisions affect the welfare of
anyone else.
Costless contracts: Even with small numbers of sellers and buyers, we
can achieve the perfect competition outcome.
But formal contracts are often costly and incomplete: legal
enforcement, uncertainties, which contingencies to include
Informal contracts? Self-enforcing?

Prediction and Design
Game Theory helps in a real world of costly contracts -

1 Predicts (or analyses) what will happen under different contractual
arrangements.
F What are the incentives?
2 Allows us to choose (or to design) the best one.
F Choosing the Game, e.g.
F Make or Buy? (production integration)
F Debt or Equity? (capital structure)
F Privatized or Publicly Owned? (ownership)
F Division or Spin Off? (organizational structure)

Principal - Agent structure
Principal - the party who designs the contract

Agent - the party who decides whether to accept or reject.
Once accepted, a formal contract is binding.
But this necessitates that the contract is based on what is observable
and verifiable.
The pervasive Principal-Agent problems:
I author v. publisher
I debt v. equity
I landlord v. tenant
I subcontractor v. price contract
I employer v. employee
I insured v. insurer

Creating Incentives
How can you make it in another person’s interest to behave as you

want? Especially with a divergence of interests, aims.
How can you create appropriate incentives?
Rewards & punishments - carrots & sticks.
Creating incentives
I High hurdle and a lot of money
I Low hurdle and a little money

What are the main issues?
Hidden characteristics, adverse selection, and screening

I Associate others’ unobservable traits with their observable actions
Hidden actions, moral hazard, and incentives
I Associate others’ unobservable actions with observable outcomes

Hidden characteristics and adverse selection
The agent has some private information (characteristics / type)

relevant for transaction that the principal doesn’t know.
The contract cannot be based on this characteristics.
Examples:
I Employer and employee (productivity)
I Insurer and insured (risk)
I Venture capitalist and entrepreneur (technology)
I Buyer and seller (product quality)

Education as a screening device
B wants to hire W, but can’t tell (private info) whether W is:
I highly productive (HP) or
I less productive (LP)
HP workers are worth 200 to B, but LP workers are worth 100.
W knows his worth.
Competition from other employers forces B to pay the full amount of
W’s perceived worth at the time of hiring.
W can choose to receive education before trying for a job, and get a
diploma.
Education has no effect on productivity, but is observed by B - an
extreme (”credentialist” ) view of education.
Assume that schooling costs a LP worker more than an HP worker:
120 against 60. Why? Extra tutoring, etc.

A Screening Equilibrium
B offers two contracts:

1 An employee with diploma will be paid 200
2 An employee without diploma will be paid 100
If W is HP and
I earns a diploma, then he earns net 200 − 60 = 140.
I Without the diploma, W earns net 100,
⇒ education is profitable for HP W.
If W is LP and
I has no diploma, then he earns net 100.
I With the diploma W earns net 200 − 120 = 80.
=⇒ education is unprofitable for LP W.
Each worker type will choose the contract meant for it and the
separation of types is achieved.

Venture Capital
A venture’s success depends on whether a new technology will work.

50% chance it works
I venture worth 20 million if it works
I venture worth 0 if it doesn’t work
Entrepreneur knows whether the technology works or not
Entrepreneur approaches you: “I am somewhat risk averse and hence
prefer to take a smaller than 100% stake”
How much are you willing to pay if she offers you
I 90% stake
I 50% stake

Adverse Selection
Both ”good” and ”bad” are willing to sell 50% of venture

Expected value of venture given that she wants to sell 50%
1 1
× 20 + × 0 = 10
2 2
I average selection if you buy 50%

Only bad entrepreneurs is willing to sell 90% of venture
Expected value of venture given that she wants to sell 90% is 0
I adverse selection if you buy 90%
Because of this “adverse selection”, you are willing to pay less for a
larger stake!!
Still not ideal: you only want to invest when technology works!

How to Screen
Want to know an unobservable characteristics

Identify a ” hurdle” such that:
I those who jump the hurdle get some benefit but at some cost
I ”good” types find the benefit exceeds the cost
I ”bad” types find the cost exceeds the benefit
This way we get self-selection: only ”good” types will jump the
hurdle

Adverse Selection - Hidden Information
How to differentiate between good risk and bad risk?
Insurance market:
I Health: Some people are more healthy than the other.
I Auto: Condition of the car is known to the owner. The insurance
company doesn’t know how reckless the driver is.
Credit market: Some borrowers invest in projects which are riskier

than the projects of the others.

Auto Insurance
Hidden Trait: high or low risk?

Half of the population are high risk, half are low risk
High risk drivers: 90% chance of accident
Low risk drivers: 10% chance of accident
Accidents cost Rs.10000
Each driver is willing to pay Rs.1000 to avoid the risk of accident.
The insurance company can not tell who is high or low risk
Expected cost of accidents:

1 9 1 1
. + . 10000 = Rs.5000
2 10 2 10
Offer Rs.6000 premium contract to make Rs.1000 profit per customer

Self-Selection
High risk drivers:

I Don’t buy insurance: (.9)(−10, 000) = −9K + cost of risk
I Buy insurance: −6K
High risk drivers buy insurance
Low-risk drivers:
I Don’t buy insurance: (.1)(−10, 000) = −1K + cost or risk
I Buy insurance: −6K
Low risk drivers do not buy insurance
Only high risk drivers buy insurance

Adverse Selection
Expected cost of accidents in population Rs.5000

Expected cost of accidents among insured Rs.9000
Insurance company loss: Rs.3000 per customer
”adverse selection”
If only going to have high risk drivers, might as well charge more
(Rs.10000)
But then the company serves only half of the potential customers.

Screening
Offer two contracts, so that the customers self-select

One with low premium and high deductibles aimed at low-risk drivers
The other with high premium and low deductibles aimed at high risk
drivers.
Intuition:
1 The high risk customers are willing to pay relatively more to avoid risk
and would like to have more coverage. Hence, high premium and low
deductible.
2 For the low risk customers the accident is less likely. So they would
prefer the low premium and higher deductibles.

Medical insurance with two risk groups
50% of the population have good health and the rest have bad
health.
A person with good health faces 10% chance of falling sick.
A person with bad health faces 30% chance of falling sick.
The insurance companies do not know whether a customer has good

or bad health.
Each person earns $100 per week. Sickness results in $100 worth of
weekly medical expenses.

Minimum acceptable premium
Suppose the insurance company charges same premium to everyone

who buys insurance.
The average payment for the insurance company is
[.5 ∗ .1 + .5 ∗ .4] 100 = 25
To break even, an insurance company must charge a weekly premium

of $25.

Maximum premium
Every individual has a utility function over money u (x) = x .5 .
The maximum premium a person is willing to pay is equal to the

money for sure at which he/she would be indifferent between this
amount and the gamble the/she faces when he/she doesn’t buy
insurance.

Maximum premium for the group with good health
For a person with good health expected utility from not buying
insurance is
.9 ∗ 100.5 + .1 ∗ 0.5 = 9
and expected utility from buying insurance at a premium q is
(100 − q).5
Hence, a person with good health would buy insurance if

(100 − q).5 ≥ 9
⇒ 100 − q ≥ 81
⇒ q ≤ 100 − 81 = 19
The maximum weekly premium a person with good health is willing

to pay is $19.
Maximum premium for the group with bad health
Similarly, a person with bad health will buy insurance at premium q if
(100 − q).5 ≥ .6 ∗ 100.5 + .4 ∗ 0.5

⇒ 100 − q ≥ 36
⇒ q ≤ 100 − 36 = 64
The maximum weekly premium a person with bad health is willing to

pay is $64.

Market failure
If everybody is charged the same premium, then an insurance
company breaks even at weekly premium of $25.
However, only people with bad health will buy insurance at such a
premium.
But then the expected payment of the insurance company per insured
person would be
.4 ∗ 100 = 40
Hence at $25 weekly premium, the insurance company would lose

40 − 25 = 15 dollars per insured person.
To break even, the insurance company would have to raise weekly

premium to $40.
People with good health are left out
If insurance companies cannot distinguish between good and bad
health risks, they will focus on people with bad health risks.
If they could distinguish between the good and bad health risks, they
can break even by charging a weekly premium of dollar
.1 ∗ 100 = 10
to people with good health.
Unfortunately, the insurance companies cannot distinguish between
people with good and bad health risks and as soon as an insurance
company charges $10 weekly premium, bad health risk people will buy
health insurance at this lower premium as well. Then, again the
insurance companies would incur loss.
So, people with good health are left out of insurance. Not all
mutually beneficial trades are made in this market and we have
market failure due to adverse selection.
Potential solutions
Medical examinations: The insurance companies may demand a

medical check-up before insurance. This may determine whether
prople have good or bad health risks. As long as the health check-up
costs less than $9 per week, the good health risks would participate.
$9 is the difference between the maximum premium they are willing
to pay ($19) and the premium they have to pay if they are identified
as good risks ($10). But what if the medical check-up costs more
than $9? The same problem recurs.

Potential solutions
Signaling: The good health risks may somehow attempt to convey

that they are good risks. But such signals are often costly, and to be
credible they must be such that bad health types do not have
incentives to mimic them.
Screening: The insurance companies offer separate policies for

separate risk groups. For example, one policy may include lower
premium with deductible while the other may include higher premium
without deductible. The policies are chosen in a way such that each
group willingly chooses the policy meant for it.

Screening with deductible
Suppose two policies are offered by the insurance companies.
1 Policy 1: A premium of 10 cents per dollar of coverage with $D
deductible.
2 Policy 2: A premium of 40 cents per dollar of coverage with no
deductible.
Policy 1 is meant for people with good health, policy 2 for people
with bad health.
If every person with good health opts for policy 1 and every person
with bad health chooses to buy policy 2, the insurance companies
earn zero profit.
A person buying policy 1 pays total premium of

.1 ∗ (100 − D) = 10 − .1D dollars.
A person buying policy 2 pays total premium of .4 ∗ 100 = 40 dollars.

Incentive compatibility constraint for good health group
A person with good health has incentive to buy policy 1 if
.9 ∗ (100 − 10 + .1D).5 + .1 ∗ (100 − 10 + .1D − D).5

= .9 ∗ (90 + .1D).5 + .1 ∗ (90 − .9D).5
≥ .9 ∗ (100 − 40).5 + .1 ∗ (100 − 40).5
= 60.5
The LHS and RHS are expected utilities from buying policies 1 and 2
respectively for a person with good health.

Incentive compatibility constraint for bad health group
A person with bad health has incentive to buy policy 2 if
.6 ∗ (100 − 40).5 + .4 ∗ (100 − 40).5

= 60.5
≥ .6 ∗ (100 − 10 + .1D).5 + .4 ∗ (100 − 10 + .1D − D).5
= .6 ∗ (90 + .1D).5 + .4 ∗ (90 − .9D).5
The LHS and RHS are expected utilities from buying policies 2 and 1
respectively for a person with bad health.

Incentive compatibility

Participation constraints
The bad health risk group is buying the same policy as before. They
are not worse off.
The good health risk group is now better off than their next best
alternative which is buying no insurance. They are paying the fair
premium but buying a policy with less than full coverage. No problem
with participation.

Check with D = 80
At D = 80, the incentive compatibility for good health risk group is
satisfied since
.9 ∗ (90 + .1 ∗ 80).5 + .1 ∗ (90 − .9 ∗ 80).5 = 9.334 > 7.746 = 60.5
The incentive compatibility for bad health risk group is satisfied since
.6 ∗ (90 + .1 ∗ 80).5 + .4 ∗ (90 − .9 ∗ 80).5 = 7.637 < 7.746 = 60.5
The participation constraints for both groups are satisfied.
The insurance companies are earning zero profit since each group’s
premium per dollar of coverage is equal to the probability of getting
sick for that group.
Is it efficient?
No. With full information, the good health type would get full
coverage.
Because there is lack of information, the good health type only gets
partial coverage. The expected utility of each person with good
health is lower than would be under full information.
But screening improves the outcome.

Bargaining with a Customer
Customer either willing to pay Rs.20 or Rs.10, equally likely

Your price is Rs.15 (zero costs), but customer asks for a deeply
discounted price of Rs.5
You don’t know whether the customer has value Rs.20 or Rs.10

Bargaining with a Customer

Seller’s decision
Seller’s equilibrium choice depends on its belief about likelihood of

High Value vs. Low Value
I By Don’t Discount, seller is risking 5 to gain 10.
I Don’t Discount if p > 13 .
Other Approaches?
If a customer “pleads poverty” for a discount, you have other options

than simply to grant/refuse request
What else might you do?
Clearance Sale
Product only available with prob. q for those who Wait
Running the Clearance Sale costs 1

Clearance Sale

Clearance Sale as Screen
Clearance is an effective screen if q < 13 .

Clearance Sale?
p > 13 : No discount better than discount

p < 13 : Discount better than no discount

When (not) to have Clearance Sale (p < 13 )
Clearance Sale vs. Sale

I Clearance gives +9 more on High
I Clearance loses 1 + 5(1 − q) on Low
Only have Clearance when chance of High is sufficiently large

When (not) to have Clearance Sale (p > 13 )
Clearance Sale vs. No Sale

I Clearance gives −1 + 5q more on Low
I Clearance loses 1 on High
Only have Clearance when chance of High is sufficiently low

When to have Clearance Sale (p = 13 )
If Clearance is ever your best strategy, it must be when you are

indifferent between Sale and No Sale (p = 13 ).
I ”when you cant decide whether to offer a High-or Low-Quality product,
offer both!!”

Versioning
Suppose that high-quality/high-cost item will be equally profitable as

low-quality/low-cost item
In this case, you can always do better offering a menu of both items
that acts as a consumer screen
Consumer’s willingness to pay:
Good product costs 5, bad product 0

Versioning
If you decide to sell only good quality, you can sell to both high value
or low value consumers by charging price = 20, or, only to high value
by charging price = 35.
I Your profit
(20 − 5) ∗ 2 = 30
or
(35 − 5) = 30
Only bad quality is sold, your profit is
(15 − 0) ∗ 2 = 30
If you decide to sell both qualities (good to high value and bad to low
value consumers), the maximum price you can charge for good quality
is 30. Why?
I Then your profit is
(30 − 5) + (15 − 0) = 40
Takeaway
Strategic issues arise when different players have different information

Adverse selection given hidden trait
In design of optimal contract, role for screening.
Design incentive contracts to induce proper self-selection.
Remember that you need to leave some surplus for more informed
parties to achieve this.

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Designing Contracts under Hidden Information

Sukanta Game Theory 9 November, 2019 1 / 46

A contract is an agreement that supports exchange between supplier

Sukanta Game Theory 9 November, 2019 2 / 46

Game Theory helps in a real world of costly contracts -

Sukanta Game Theory 9 November, 2019 3 / 46

Principal - the party who designs the contract

Sukanta Game Theory 9 November, 2019 4 / 46

How can you make it in another person’s interest to behave as you

Sukanta Game Theory 9 November, 2019 5 / 46

Hidden characteristics, adverse selection, and screening

Sukanta Game Theory 9 November, 2019 6 / 46

The agent has some private information (characteristics / type)

Sukanta Game Theory 9 November, 2019 7 / 46

Sukanta Game Theory 9 November, 2019 8 / 46

B offers two contracts:

Sukanta Game Theory 9 November, 2019 9 / 46

A venture’s success depends on whether a new technology will work.

Sukanta Game Theory 9 November, 2019 10 / 46

Both ”good” and ”bad” are willing to sell 50% of venture

I average selection if you buy 50%

Sukanta Game Theory 9 November, 2019 11 / 46

Want to know an unobservable characteristics

Sukanta Game Theory 9 November, 2019 12 / 46

How to differentiate between good risk and bad risk?

Credit market: Some borrowers invest in projects which are riskier

Sukanta Game Theory 9 November, 2019 13 / 46

Hidden Trait: high or low risk?

Offer Rs.6000 premium contract to make Rs.1000 profit per customer

Sukanta Game Theory 9 November, 2019 14 / 46

High risk drivers:

Sukanta Game Theory 9 November, 2019 15 / 46

Expected cost of accidents in population Rs.5000

Sukanta Game Theory 9 November, 2019 16 / 46

Offer two contracts, so that the customers self-select

Sukanta Game Theory 9 November, 2019 17 / 46

A person with good health faces 10% chance of falling sick.

A person with bad health faces 30% chance of falling sick.

The insurance companies do not know whether a customer has good

Sukanta Game Theory 9 November, 2019 18 / 46

Suppose the insurance company charges same premium to everyone

The average payment for the insurance company is

[.5 ∗ .1 + .5 ∗ .4] 100 = 25

To break even, an insurance company must charge a weekly premium

Sukanta Game Theory 9 November, 2019 19 / 46

Every individual has a utility function over money u (x) = x .5 .

The maximum premium a person is willing to pay is equal to the

Sukanta Game Theory 9 November, 2019 20 / 46

Hence, a person with good health would buy insurance if

The maximum weekly premium a person with good health is willing

Similarly, a person with bad health will buy insurance at premium q if

(100 − q).5 ≥ .6 ∗ 100.5 + .4 ∗ 0.5

The maximum weekly premium a person with bad health is willing to

Sukanta Game Theory 9 November, 2019 22 / 46

Hence at $25 weekly premium, the insurance company would lose

To break even, the insurance company would have to raise weekly

Medical examinations: The insurance companies may demand a