Advanced Microeconomics 6QQMN970: Exercise

Sheet 6
Niall Hughes

1. A government agency can outsource a contract to a firm who is privately informed

about its cost. The agency believes that the firm’s cost is cH with probability α
and cL < cH with probability (1 − α). The agency receives V if the project is
implemented.
(i) Assume the agency makes a take it or leave it offer of payment t to the firm.
Assume the firm accepts an offer it is indifferent. Solve for the optimal offer
and agency surplus.
(ii) Assume now that the agency can offer a menu of contracts of the type (q, t)
where t is the up-front payment to the firm and q is the probability that the
project is implemented. Stated differently, a firm that selects contract (q, t)
receives t for sure and then has to implement the project with probability
q. Write down the agency screening problem, the participation constraints
and the incentive compatibility constraints.
(iii) Argue that P CH and ICL must bind in any optimal contract.
(iv) Solve for the optimal contract. Can the agency benefit from screening?Why/Why
Not?

(i) The monopolist can either outsource to both types or only to the low cost
type. In the first case, participation of the high cost type requires t = cH
which also implies the participation of the low cost type. The agency’s
surplus is V − cH under t = cH .
In the second case, only the low type firm is willing to participate and
we have t = cL . The surplus of the agency is (1 − α)(V − cL ) as only
the low cost type participates. The agency outsources to both types if
V − cH > (1 − α)(V − cL ).

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(ii) We have
• P CL : tL − qL cL ≥ 0
• P CH : tH − qH cH ≥ 0
• ICL : tL − qL cL ≥ tH − qH cL .
• ICH : tH − qH cH ≥ tL − qL cH .
The agency maximizes α(qH V − tH ) + (1 − α)(qL V − tL ) subject to the
four constraints.
(iii) This argument is identical to that done in the lecture.
P CH must bind. Using P CL and ICL we have tL − qL cL ≥ tH − qH cL >
tH − qH cH , so it must be that P CL > P CH . It cannot be that P CL >
P CH > 0 - otherwise the agency could reduce both tL and tH by the same
small amount  and all four constraints would still hold while surplus
would increase. This is a contradiction.
How is it that all 4 constraints still hold? ICL and ICH will still hold
because you are we are reducing both sides of these inequalities by the
same amount . We might be worried that if we decrease tL and tH that
P CL and P CH are no longer satisfied. Because we have assumed we have
P CL > P CH > 0, the government agency can choose  to be as small
as it likes, so that be decreasing tL and tH by  will either mean we still
have P CL > P CH > 0 or else we have P CL > P CH = 0. In either case
the constraints are not violated. In a nutshell, the argument is that if
both P CL and P CH are slack, the govt agency can keep reducing trans-
fers by a small amount until one of them binds. Once one of the PCs
bind, the govt agency can no longer decrease transfers without violating
a constraint. You might wonder which PC will bind? We proved above
that P CL > P CH , therefore it must be that P CH = 0.

ICL binds. Otherwise the agency could decrease tL and all constraints
would hold while surplus would increase. This is a contradiction.
What is going on here? It’s a very similar argument to the one above.
To prove that ICL binds we suppose instead that it is slack and then
we try to find a contradiction. So, suppose ICL is slack. We know from
above that P CH binds and P CL is slack. What would happen if the govt
agency could decrease tL by some small amount  ? Looking at the four

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 constraints, we can see that this would decrease the right hand side of
ICH - so the constraint will still be satisfied. It will decrease the left
hand side of P CL and ICL but as both of these are slack, we can decrease
tL by a small amount such that they are both still satisfied. Therefore, if
ICL is slack the govt agency will keep decreasing tL until it binds.
(iv) We have tH = qH cH because P CH binds and tL = cL (qL − qH ) + qH cH
because ICL binds. We can sub these into the agency’s objective function
to get:
α(qH (V − cH )) + (1 − α)(qL V − (cL (qL − qH ) + qH cH ))
Ordinarily you would differentiate this objective function with respect to
qL and qH to find their optimal values. However, when you try to do that
here you get.
(1 − α)(V − cL ) = 0
and
α(V − cH ) − (1 − α)(cH − cL ) = 0
We see that qL and qH don’t appear at all. What does this mean? It
means we have a corner solution. The optimal level of qL is either 0 or 1,
and the optimal level of qH is either 0 or 1. This is because the objective
function is linear in qL and qH . Examining the objective function we see
that qL is multiplied by the term (1 − α)(V − cL ). This must be positive
because α < 1 and V > cL (If V < cL then the govt agency would never
want to outsource to either firm). Therefore it is optimal to set qL = 1.
What about qH ? It is multiplied by α(V − cH ) − (1 − α)(cH − cL ) in the
objective function - which we can re-write as V − cH − (1 − α)(V − cL ) .
Now we can see that if V − cH > (1 − α)(V − cL ) then the optimal level
is qH = 1, and so we have qH = qL = 1 and tH = tL = cH . If, however,
V − cH < (1 − α)(V − cL ) then the optimal level is qH = 0, and so we
have qH = tH = 0 and qL = 1, tL = cL . What we have found is exactly
the two solutions we found in part (i)
The monopolist’s surplus does not increase relative to take it or leave it
offer in question one - screening is fruitless here because the objective
function is linear in q - the best choice is always either q = 0 or q = 1,
which coincides with the contracts in part (i). The agency does not trade-
off at the margin rent and allocation as would be the case if the V or C
were non-linear functions of q.

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2. Assume there are two kinds of travellers: business and leisure. Leisure travellers
value travelling 6 for sure while business travellers value travelling 0 with prob-
ability half and 10 with probability half. A monopoly seller can offer a menu of
refund contracts. For each refund contract, a consumer has to pay the up-front
price and is eligible for a set-refund in the event of cancellation (assume the
refund cannot be greater than the price paid). Assume the cost of serving the
consumer is 0 and consumers get 0 surplus in the event they do not travel. Derive
the profit maximizing menu of contracts. (Hint: consider a menu of contracts
that extracts all consumer surplus.)

The profit of the firm is pL + pB − 0.5rB if each type chooses the contract meant
for them. We have the following PCs and ICs:
• P C L : 6 − pL ≥ 0
• P CB : (0.5)(10 − pB ) + (0.5)(0 − pB + rB ) = 5 − pB + 0.5rB ≥ 0
• ICL : 6 − pL ≥ 6 − pB .
• ICB : 5 − pB + 0.5rB ≥ 5 − pL + 0.5rL .
We must have pL ≤ 6 and pL ≤ pB for P CL and ICL to hold. We are free to
set rL = 0 as it only appears on the right hand side of ICB . Furthermore, we
are free to set pL = 6 so long as pL ≤ pB , as this will increase profits. P CB
implies that rB ≥ pB0.5−5 ≥ 2 where second inequality comes from the fact that
pB ≥ pL = 6. With rL = 0 and pL = 6 it must be that the right hand side
of ICB is negative. Therefore, P CB must bind before ICB does. We are free
to set any pB , rB so long as 5 + 0.5rB ≥ pB ≥ pL = 6 There are two cases to
consider.
• First suppose pB = pL = 6 and rB = 2 , rL = 0. This would still satisfy all
four constraints, making both PC’s bind. With this set of contracts the
monopolist makes a profit of 6 from leisure travellers and 5 from business
travellers.
• Now suppose pB > pL = 6 and rB > rL = 0. We can choose any pB and
rB such that pB = 5 + 0.5rB . There are a whole range of contracts the
monopolist may offer the business customer such that these conditions
are met. For example (pB , rB ) = (10, 10) or (pB , rB ) = (7, 4) etc. In each
case the expected profits of the monopolist from the business traveller is
5 while his profits from the leisure traveller is 6.

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3. A risk neutral company offers insurance against the risk of a car accident. There
are two types of agents, characterized by their probability to have an accident.
Careful drivers (G) face a low probability of accident πG while risky drivers
(B) are more likely to have an accident with probability πB > πG . Denote the
proportion of G type agents with q. If no accident occurs, the value of the car is
y, while if an accident occurs, the damaged car is worth y − d. Agents are risk
averse with utility u(.). Agents can take out insurance. They pay a pz for the
policy and in the event of an accident they receive a payoff of z. Let y N A and
y A be a drivers net wealth in case of an no accident and in case of an accident
respectively.

(i) Suppose a driver buys an insurance policy (p, z). What is his net wealth in
each state, y N A and y A ? Give your answers in terms of y, d, z, p.
(ii) What is the expected utility of agent i = G, B when offered insurance (p, z)?
What are the expected profits of the firm if it offers a single contract (p, z)
to both drivers? What are its expected profits under if it offers separate
contracts (pG , zG ), (pB , zB ) for good and bad drivers?
(iii) Suppose insurers can observe whether drivers are Good or Bad. Solve for the
preferred level of insurance coverage for each type G, B such that insurers
make zero profit.
(iv) Describe this situation of contracts with observable types graphically.(Put
y N A on the x-axis, y A on the y-axis. Derive the utility functions of each
driver and the isoprofit lines of the firm. Show on the graph where the
optimal policies for each driver are)
(v) Assume there are ≥ 2 firms in the market competing for agents. Show that
firms earn 0-profits.
(vi) Can a pooling contract (p, z) exist? Why (not)?

(i) We have y N A = y − pz and y A = y − d + z − pz.

(ii) Utility for type i = {G, B} in case of an accident is

u(y A ) = u(y − d + z − pz)

u(y N A ) = u(y − pz)

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 Expected Utility is

EUG = (1 − πG )u(y N A ) + πG u(y A )

EUB = (1 − πB )u(y N A ) + πB u(y A )

Expected Profits are: Under a pooling contract (p, z) where both types
pay the same price and get the same cover.

EΠpool = q[(1 − πG )(pz) + πG (pz − z)] + (1 − q)[(1 − πB )(pz) + πB (pz − z)]

Under separation where good drivers take the contract (pG , zG ) and bad
drivers take the contract (pB , zB )

EΠG = (1 − πG )pG zG + πG (pG zG − zG )

EΠB = (1 − πB )pB zB + πB (pB zB − zB )

So total profits are

EΠsep = q[(1−πG )(pG zG )+πG (pG zG −zG )]+(1−q)[(1−πB )(pB zB )+πB (pB zB −zB )]

(iii) The preferred level of insurance for each type is that which maximises
their utility. But in order for that level to be offered, we need that firms
do not make negative profits. Therefore we maximise the expected utility
of each type subject to firms earning zero profits on that contract.
Here I show it for good drivers - the case for bad drivers is identical.

max πG u(y − d + zG − pG zG ) + (1 − πG )u(y − pG zG )

pG ,zG

subject to

EΠG = (1 − πG )(pG zG ) + πG (pG zG − zG ) = 0

we can rearrange this no-profit condition to see that

p G = πG

and we can sub this directly into the objective function to get

max πG u(y − d + (1 − πG )zG ) + (1 − πG )u(y − πG zG )

zG

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 Taking the FOCs we get
πG (1 − πG )u0 (y − d + (1 − πG )zG ) − (1 − πG )πG u0 (y − πG zG ) = 0
this simplifies to the marginal utility must be equal in each state of the
world
u0 (y − d + (1 − πG )zG ) = u0 (y − πG zG )
In order for these to be equal it must be that zG = d i.e. there is full
insurance. The optimal contract for the Good type (in which the firm
makes zero profits) is (pG , zG ) = (πG , d). That is, he paid an actuarially
fair price for insurance (pG = πG ), and he is fully insured zG = d.
We can follow exactly the same process for the Bad type to find (pB , zB ) =
(πB , d).
(iv) First note that if y N A is on the x-axis and y A is on the y-axis, then the
following must be true:
• Full insurance policies lie on the 45 degree line from the origin, as
with full insurance the insured has the same income in both states
of the world.
• The original allocation of the person if uninsured is A = (y, y − d),
this is always available, so any policy must give at least as much
utility as this.
• The indifference curves of a Good driver are steeper than those of a
Bad driver. Why? Good drivers care less about their utility in the
state of the world where they have an accident, because this event
is less likely to occur for them.
• What is the slope of a driver’s indifference curve? We know that
expected utility is
πi u(y A ) + (1 − πi )u(y N A )
to find the indifference curve in the (y N A , y A ) space we take the
derivative with respect to y N A and set the FOC equal to zero - be-
cause we want to find how much a small increase in y N A must be
offset by a small decrease in y N A such that today utility remains
unchanged. This gives us
dy A
πi u0 (y A ) N A
+ (1 − πi )u0 (y N A ) = 0
dy

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 which we can re-arrange to
dy A (1 − πi )u0 (y N A )
= −
dy N A πi u0 (y A )
This is the slope of a drivers indifference curve.
• Note that because profits are just net payments from the policy
holder, the more we move to the origin, the higher are profits. the
lower are y A and y N A , the higher are firm profits. Next we want to
work out the shape of iso-expected profit lines. That is points where
the insurer makes the same amount of expected profit. Note that on
the iso-expected profit line of a firm it must be that the expected
income of the insured is also constant. The isoprofit line and the
line of constant expected income are the same. This is because the
expected profits are
EΠi = (1 − πi )(pi zi ) + πi (pi zi − zi ) = Π̄i (1)
While expected income is
(1 − πi )(y − pi zi ) + πi (y − d + zi − pi zi ) = ȳi (2)
Where Π̄ and ȳi are some constant levels of profits and income re-
spectively. Using Equation 1 we can rewrite Equation 2 as
(1 − πi )(y) + πi (y − d) − Π̄i = ȳi
to see that the greater are profits for the firm, the lower will be
expected income for the driver.
We can also write Equation 2 as
(1 − πi )(y N A ) + πi (y A ) = ȳi
Now, because our graph has y N A on the x-axis and y A on the y-axis,
we can find the slope of this line by rearranging the above equation
to
ȳi (1 − πi ) N A
yA = − (y )
πi πi
So we see the slope of this line is −(1−π
πi
i)
. We know have the slope
of the iso-expected profits lines and the slopes of the indifference
curves.

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• The zero profit line for a policy must go through point A (because
this is the outside option of no insurance and thus zero profits) and
must have a slope of −(1−ππi
i)
as we found. Any point on that line
would be actuarially fair (pi = πi ). This means with separating
contracts the zero profits line for Good drivers has a slope of −(1−π
πG
G)

−(1−πB )
while for bad drivers it has a slope of πB
.
• At the optimal contract(s), the slopes of the indifference curves co-
incide with the slopes of the corresponding iso-expected profit lines
of the firm:
(1 − πi )u0 (yN A ) 1 − πi
− 0
=−
πi u (yA ) πi
which gives us that at an optimum u (yN A ) = u0 (yA ) i.e. the optimal
0

contracts provide full insurance. These optimal contracts lie on the

zero profit lines for each type of driver because we were looking for
the optimal packages for the insured subject to firms making zero
profits on the contract.
• For a pooling contract a “fair” contract will have a premium of π̃ =
qπG + (1 − q)πB . The expected profits of the firm are
EΠpool = q[(1−πG )pz+πG (z−pz)]+(1−q)[(1−πB )pz−πB (z−pz)] = Π̃
Again we’ll use the trick that along any iso-expected profit line,
the expected income of the expected purchaser of that contract is
constant. So we can write the expected income of a random person
insured under the pooling contract as
q[(1 − πG )y N A + πG y A ] + (1 − q)[(1 − πB )y N A + πB y A ] = ỹ
Where Π̃¯ and ỹ are some constant levels of profits and income re-
spectively. Now, because our graph has y N A on the x-axis and y A
on the y-axis, we can find the slope of this line by rearranging the
above equation to read
ỹ q(1 − πG ) + (1 − q)(1 − πB ) N A
yA = − (y )
(qπG + (1 − q)πB ) (qπG + (1 − q)πB )

which we can rewrite as

ỹ 1 − π̃ N A
yA = − (y )
π̃ π̃

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 So we see the slope of this line is − 1−π̃
π̃
.

• As we saw before, At the optimal contract(s), the slopes of the in-

difference curves coincide with the slopes of the corresponding iso-
expected profit lines of the firm - this time the pooling iso-profit
line:

(1 − πi )u0 (yN A ) 1 − π̃
− 0
=−
πi u (yA ) π̃

We can see clearly from the graph, the implications of πG < π̃ < πB .
The price of insurance is now cheaper than before for the bad type
and more expensive for the good type. Therefore, at a price π̃ the
bad type will want to over-insure choosing more than full insurance
while the good type will want to underinsure choosing less than full
insurance. The firm will make losses on the first type and profits
on the second. There is a risk of this market unravelling, similar
to the market for lemons. This is because any customer who wants
to buy more insurance than the level at point E G in the graph will
reveal himself as a high risk type, and the firm will not sell this
contract as it will be sure to make a loss on it. The only pooling
contract that could potentially exists is the one at E G because at
that point all customers want to buy it, and so the proportion of
good drivers buying the contract is about q, so the firm makes zero
profits overall. We will see in part (v) though that such a pooling
contact is not robust to competition.

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(v) We want to show that EΠ = 0. Suppose first that EΠ > 0, then another
firm could offer a contract with an  lower price and/or  higher coverage
such that, all agents would accept as they were better off, while the firm
still makes not negative profits. (This a a simple Bertrand competition
argument). This rationale can be applied to both pooling and separating
cases. In general an equilibrium is based on the fact that no firm can add
a contract that would give positive expected profits from the type(s) of
agent that prefer this new contract to the old one (either B or G or both).
This implies zero expected profits.

(vi) NO. A pooling contract is NOT robust to competition. Consider the

graph below. Denote a pooling contract (p, z)

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Any pooling equilibrium must be on the zero profit pooling line
Πpool = q[(1 − πG )pz + πG (z − pz)] + (1 − q)[(1 − πB )pz + πB (z − pz)] = 0
which we can re-write as
Πpool = (1 − π̃)pz + π̃(z − pz) = 0
remembering that
π̃ = qπG + (1 − q)πB
is the probability that there will be an accident when the firm does not
know which type the agent is.
Looking at the graph we see any competitor firm could offer a contract in
the shaded area, i.e. between the high and low type indifference curves.
This contract would only attract G types (good drivers or low risk guys
with steeper indifference curves) while all B types would not be willing to
take it. This contract would however be below the ΠG = 0 line and hence
imply EΠ > 0 for the competitor. So we could expect some other firm
to be willing to offer such a contract right away. This would leave the
expected profits for the other firm to be negative as they only attract B
types anymore. So we conclude that a pooling equilibrium cannot exist.

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