The Basics of Contractual Screening

Let us begin by broadly describing the situation in which we are interested. We shall fill in the blanks as we proceed through this reading.

• Two players are involved in a strategic relationship; that is, each player’s well being depends on the play of the other player.

• One player is better informed (or will become better informed) than the other; that is, he has private information about some state of nature private information relevant to the relationship. As is typical in information economics, we refer to the player with the private information as the informed player informed player and the player without the private information as the uninformed player.

• Critical to our analysis of these situations is the bargaining game that determines the contract. We will refer to the contract proposer as the principal and the player who receives the proposal as the agent. More- principal over, we assume contracts are proposed on a take-it-or-leave-it basis: The agent agent’s only choices are to accept or reject the contract proposed by the principal. Rejection ends the relationship between the players. A key assumption is that the principal is the uninformed player. Models like this, in which the uninformed player proposes the contract, are referred to as screening models. In contrast, were the informed player the contract screening proposer, we would have a type of signaling model.

• A contract can be seen as setting the rules of a secondary game to be played by the principal and the agent.

Given this information structure, the two parties interact according to some specified rules that constitute the extensive form of a game. In this two-person game, the players must contract with each other to achieve some desired outcome. In particular, there is no ability to rely on some exogenously fixed and anonymous market mechanism. Our focus will be on instances of the game where the informed player can potentially benefit from his informational advantage (e.g., perhaps inducing a buyer to pay more for a good than necessary because she fears the seller is high cost). But, because the informed player doesn’t have the first move—the uninformed player gets to propose the contract—this informational advantage is not absolute: Through her design of the contract, the uninformed player will seek to offset the informed player’s inherent advantage.

The Two-Type Screening Model

We will begin to formalize these ideas in as simple a model as possible, namely the two-type model. In the two-type model, the state of nature can take one of two-type model two possible values. As is common in this literature, we will refer to the realized state of nature as the agent’s type. Given that there are only two possible state, the agent can have one of just two types.

Before proceeding, however, we need to emphasize that such simplicity in modeling is not without cost. The two-type model is “treacherous,” in so far as it may suggest conclusions that seem general, but that are not. For example, the conclusion that we will shortly reach with this model that the optimal contract implies distinct outcomes for distinct states of nature—a result called separation —is not as general as it may seem. Moreover, the assumption of two separation types conceals, in essence, a variety of assumptions that must be made clear. It similarly conceals the richness of the screening problem in complex, more realistic, relationships. Our view is that few economic prescriptions and predictions should be reached from considering just the two-type model. Keeping this admonition in mind, we now turn to a simple analysis of private procurement in a two-type model.

Assignments

1. What does the term ‘hidden information’ mean?

2. Give some examples of hidden information.

3. What does the term ‘model’ mean? Find the paragraph where this term is used and translate it.

4. Explain the model shown below.

The Basics of Contractual Screening - student2.ru
Model 1.1 Information Communities Model