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\begin{LARGE}
\parindent 24pt \parskip 10pt
\noindent 30 January 2006. Eric Rasmusen, Erasmuse@indiana.edu.
Http://www.rasmusen.org.
Overheads for Chapter 10 of {\it Games and Information}.
\noindent 22 November 2005. Eric Rasmusen, Erasmuse@indiana.edu. \\
Http://www.rasmusen/org/GI/chap10\_mechanisms.pdf.
\begin{LARGE}
\begin{center}
{ \bf 10 Mechanism Design and Post-Contractual Hidden Knowledge }
\end{center}
\end{LARGE}
\newpage
\begin{center}
{\bf Production Game VIII: Mechanism Design }
\end{center}
{\bf Players}\\
The principal and the agent.
\noindent
{\bf The Order of Play}\\
1 The principal offers the agent a wage contract of the form $w(q,m)$, where $q$
is output and $m$ is a message to be sent by the agent.\\
2 The agent accepts or rejects the principal's offer.\\
3 Nature chooses the state of the world $s$, according to probability
distribution $F(s)$, where the state $s$ is $good$ with probability 0.5 and
$bad$ with probability 0.5. The agent observes $s$, but the principal does
not.\\
4 If the agent accepted, he exerts effort $e$ unobserved by the principal, and
sends message $m \in \{good, bad\}$ to him. \\
5 Output is $q(e, s)$, where $q(e, good) =3e$ and $q(e,bad) =e$, and the wage
is paid.
\noindent
{\bf Payoffs}
Agent rejects: $\pi_{agent} = \bar{U}=0$ and $
\pi_{principal} = 0$. \\
Agent accepts: $\pi_{agent}= U(e,w,s)=w-e^2$ and
$\pi_{principal}= V(q - w)=q-w$.
Production Game VII, adverse selection version: two participation constraints and two
incentive compatibility constraints. PG VIII, moral hazard with hidden info: one participation constraint.
\newpage
The first-best is unchanged from Production Game VII: $e_g=1.5$ and $q_g =4.5$, $e_b=0.5$ and $q_b =0.5$.
Also unchanged is that the
principal must solve the problem:
\begin{equation} \label{a1}
\stackrel{Maximize}{q_g, q_b,w_g, w_b} [ 0.5 (q_g - w_g) + 0.5 (q_b-w_b)],
\end{equation}
where the agent is paid under one of two forcing contracts, $(q_g, w_g)$ if
he reports $m=good$ and $(q_b, w_b)$ if he reports $m=bad$, where producing
the wrong output for a given contract results in boiling in oil.
The self-selection constraints are the same as in Production Game VII.
\begin{equation} \label{a2}
\begin{array}{ll}
\pi_{agent} (q_g, w_g|good)& = w_g - \left( \frac{q_g}{3}
\right)^2 \\
& \geq \pi_{agent} (q_b, w_b|good)
= w_b - \left( \frac{q_b}{3}
\right)^2
\end{array}
\end{equation}
\begin{equation} \label{a3}
\pi_{agent} (q_b, w_b|bad) = w_b - q_b^2 \geq \pi_{agent} (q_g, w_g|bad)
= w_g - q_g^2.
\end{equation}
The
single participation constraint is
\begin{equation} \label{a4}
\begin{array}{l}
0.5 \pi_{agent} (q_g, w_g|good) +0.5 \pi_{agent} (q_b, w_b|bad)\\
= 0.5 \left( w_g - \left( \frac{q_g}{3} \right)^2 \right) + 0.5 \left(
w_b - q_b^2 \right) \geq 0
\end{array}
\end{equation}
\newpage
This single participation constraint is binding, since the principal wants to
pay the agent as little as possible.
The good state's self-selection constraint
will be binding. In the good state the agent will be tempted to take the
easier contract appropriate for the bad state (due to the ``single-crossing
property'' to be discussed in a later section ) and so the principal has to
increase the agent's payoff from the good-state contract to yield him at least
as much as in the bad state. He does not want to increase the surplus any more
than necessary, though, so the good state's self-selection constraint will be
exactly satisfied.
This gives us two equations,
\begin{equation} \label{a5}
\begin{array}{l}
0.5 \left( w_g - \left( \frac{q_g}{3} \right)^2 \right) + 0.5 \left( w_b
- q_b^2 \right) = 0\\
\\
w_g - \left( \frac{q_g}{3} \right)^2 = w_b - \left( \frac{q_b}
{3} \right)^2 \\
\end{array}
\end{equation}
Solving them out yields $w_b = \frac{5}{9} q_b^2$ and $w_g = \frac{1}{9} q_g^2
+ \frac{4}{9} q_b^2$.
\newpage
Returning to the principal's maximization problem in (\ref{a1}) and substituting
for $w_b$ and $w_g$, we can rewrite it as
\begin{equation} \label{a6}
\stackrel{Maximize}{q_g, q_b} \;\; \pi_{principal}= \left[ 0.5 \left(q_g -
\frac{q_g^2}{9} - \frac{4q_b^2}{9} \right) + 0.5 \left(q_b -\frac{5q_b^2}{9}
\right) \right]
\end{equation}
with no constraints. The first-order conditions are
\begin{equation} \label{a7}
\frac{\partial \pi_{principal}}{\partial q_g}= 0.5 \left(1 - \left[
\frac{2}{9} \right] q_g
\right) =0,
\end{equation}
so $q_g =4.5$, and
\begin{equation} \label{a8}
\frac{\partial \pi_{principal}}{\partial q_b}=0.5 \left( - \frac{8q_b}{9}
\right) + 0.5 \left( 1 -\frac{10q_b }{9} \right) =0,
\end{equation}
so $q_b = \frac{9}{18} =.5$. We can then find the wages that satisfy
the constraints, which are $w_g \approx 2.36$ and $w_b \approx 0.14$.
As in Production Game VII, in the good state the effort is at the first-best
level while in the bad state it is less.
The
agent does not earn informational rents, because at the time of contracting he
has no private information. In Production Game VII the wages were $w_g' \approx
2.32$ and $w_b'\approx 0.07$. Both wages are higher in Production Game VIII,
but so is effort in the bad state. The
principal in Production Game VIII can (a)
come closer to the first-best when the state is bad, and (b) reduce the
rents to the agent.
\newpage
\noindent
{\bf Observable but Nonverifiable Information }
If the state or type is public information, then it is straightforward to
obtain the first-best using forcing contracts. What if the state is observable
by both principal and agent, but is not public information?
We say that the variable $s$ is {\bf
nonverifiable} if contracts based on it cannot be enforced.
Maskin (1977) suggested a matching scheme to achieve the first-best which would take the following two-part form for Production Game VIII:
\noindent
{\ (1) Principal and agent simultaneously send messages $m_p$ and $m_a$ to
the court saying whether the state is good or bad. If $m_p \neq m_a$, then no
contract is chosen and both players earn zero payoffs. If $m_p=m_a$, the
court enforced part (2) of the scheme.
(2) The agent is paid the wage $(w|q)$ with either the good-state forcing
contract $(2.25|4.5)$ or the bad-state forcing contract $(0.25|0.5)$, depending
on his report $m_a$, or is boiled in oil if he the output is inappropriate to
his report. }
\newpage
Usually this kind of scheme has multiple equilibria, however, perverse
ones in which both players send false message which match and inefficient
actions result. Here, in a perverse equilibrium the principal and agent
would always send the message $m_p=m_a=bad$. Even when the state was
actually good, the payoffs would be
($\pi_{principal} (good)= 0.5-0.25>0$ and
$\pi_{agent} (good)= 0.25- (0.5)^2=0$,
Neither player would have incentive
to deviate unilaterally and drive payoffs to zero.
Perhaps a bigger problem than the multiplicity of equilibria is
renegotiation due to players' inability to commit to the mechanism.
Suppose
the equilibrium says that both players will send truthful messages, but the
agent deviates and reports $m_a=bad$ even though the state is good. The court
will say that the contract is nullified.
But
agent could negotiate a new contract with the principal.
The Maskin scheme is like the Holmstrom Teams contract, where if output was even a little too small, it was
destroyed rather than divided among the team members.
Solution:
a third party who would receive the output if it was t oo small.
\newpage
\noindent
{\bf Unravelling: Information Disclosure when Lying Is Prohibited}
\noindent
There is another special case in which hidden information can be forced into
the open: when the agent is prohibited from lying and only has a choice between
telling the truth or remaining silent.
In Production Game VIII, this set-up would give the agent two possible message
sets. If the state were good, the agent's message would be taken from $m \in
\{good, silent\}$. If the state were $bad$, the agent's message would be taken
from $m \in \{bad, silent\}$.
The agent would have no reason to be silent if the true state were bad (which
means low output would be excusable), so his message then would be $bad$. But
then if the principal hears the message $silent$ he knows the state must be
good-- $good$ and $silent$ both would occur only when the state was good. So
the option to remain silent is worthless to the agent.
\newpage
Suppose Nature uses the uniform distribution to assign the variable $s$ some
value in the interval $[0, 10]$ and the agent's payoff is increasing in the
principal's estimate of $s$.
Assume the agent cannot lie but he can conceal information. Thus, if $s = 2$, he can send
the uninformative message $m \geq 0$ (equivalent to no message), or the message
$m \geq 1$, or $m=2$, but not $m \geq 4.36$.
When $s=2$ the agent might as well send a message that is the exact truth:
``$m=2$.''
If he were to choose the message ``$m \geq 1$'' instead, the
principal's first thought might be to estimate $s$ as the average value in the
interval $[1,10]$, which is 5.5.
But the principal would realize that no agent
with a value of $s$ greater than 5.5 would want to send the message ``$m \geq
1$'' if 5.5 was the resulting deduction. This realization restricts the
possible interval to [1, 5.5], which in turn has an average of 3.25.
But then no
agent with $s > 3.25$ would send the message ``$m \geq 1$.''
The principal
would continue this process of logical {\bf unravelling} to conclude that $s=
1$.
\newpage
MODEL REPETITION: Nature uses the uniform distribution to assign the variable $s$ some
value in the interval $[0, 10]$ and the agent's payoff is increasing in the
principal's estimate of $s$. The agent cannot lie but he can conceal information.
In this model, no news is bad news.
The agent would
therefore not send the message ``$m \geq 1$'' and he would be indifferent
between ``$m=2$'' and ``$m \geq 2$'' because the principal would make the same
deduction from either message.
\noindent
ANOTHER APPROACH
The equilibrium is either fully separating or has some pooling.
If it is fully separating, the agent's type is revealed, so it might as well be $m=s$.
If it had some pooling, then two types with $s_2>s_1$ would be pooled together and the principal's estimate of $s$ would be the average in the pool. Type $s_2$ would therefore deviate to $m=s_2$ to reveal his type. So the equilibrium must be perfectly separating.
Where would this logic break down? ---
either unpunishable lying or genuine ignorance.
\newpage
\noindent
{\bf The Revelation Principle: We Can Restrict Attention to Direct Mechanisms }
Let $w$ be the agent's wage, $q$ be output, $m$ be his message, and $s$ be his type. ALLOW COMMITMENT TO CONTRACTS.
\noindent
{\bf The Revelation Principle.} {\it For every contract $w(q,m)$ that leads to
lying (that is, to $m \neq s$), there is a contract $w^*(q,m)$ with the same
outcome for every $s$ but no incentive for the agent to lie.}
A {\bf direct mechanism}--- agents tell the truth in
equilibrium--- can be found equivalent to any {\bf indirect mechanism} in
which they lie.
Suppose we are trying to design a mechanism to make people with higher
incomes pay higher taxes, but anyone who makes \$70,000 a year can claim he
makes \$50,000 and we do not have the resources to catch him.
We could design a mechanism in which higher reported incomes pay higher taxes,
but reports of \$50,000 would come from both people who truly have that income
and people whose income is \$70,000.
The revelation principle says that we can
rewrite the tax code to set the tax to be the same for taxpayers earning
\$70,000 and for those earning \$50,000, and the same amount of taxes will be
collected without anyone having incentive to lie.
\newpage
\begin{center}
{\bf The Crawford-Sobel Sender-Receiver Game}
\end{center}
{\bf Players}\\
The sender and the receiver.
\noindent
{\bf The Order of Play}\\
0 Nature chooses the sender's type to be $t \sim U[0, 10]$.\\
1 The sender chooses message $m \in [0, 10]$. \\
2 The receiver chooses action $a \in [0, 10]$. \\
\noindent
{\bf Payoffs}\\
The payoffs are quadratic loss functions in which each player has an ideal
point and wants $a$ to be close to that ideal point.
\begin{equation} \label{e200}
\begin{array}{ll}
\pi_{sender}& = \alpha - (a-[t+1])^2\\
& \\
\pi_{receiver} &= \alpha - (a-t)^2\\
\end{array}
\end{equation}
Suppose the receiver believed that the sender always sent $m=t$ and so chooses
$a=m$. Would the sender indeed be willing to tell the truth?
No. The sender would not always report $m=10$, because his ideal point
is $a=t+1$, rather than $a$ being as big as possible. If, however, the sender
thinks the receiver will believe him, he will deviate to reporting $m=t+1$,
always exaggerating his type slightly.
\newpage
\noindent
{\bf Pooling Equilibrium 1} \\
{\bf Sender:} Send $m=10$ regardless of $t$. \\
{\bf Receiver:} Choose $a=5$ regardless of $m$. \\
{\bf Out-of-equilibrium belief:} If the sender sends $m<10$, the receiver uses
passive conjectures and still believes that $t \sim U[0,10]$.
\noindent
{\bf Pooling Equilibrium 2} \\
{\bf Sender:} Send $m$ using a mixed-strategy distribution independent of
$t$ that has the support $[0,10]$ with positive density everywhere. \\
{\bf Receiver:} Choose $a=5$ regardless of $m$. \\
{\bf Out-of-equilibrium belief:} Unnecessary, since any message might be
observed in equilibrium.
In each of these two equilibria, the sender's action conveys no information and
is ignored by the receiver. The sender is happy about this if it happens that
$t=4$, and the receiver is if $t=5$, but averaging over all possible $t$, both
their payoffs are lower than if the sender could commit to truthtelling.
\newpage
\noindent
{\bf Partial Pooling Equilibrium 3} \\
{\bf Sender:} Send $m=0$ if $t \in [0,3]$ or $m=10$ if $t \in [3,10]$. \\
{\bf Receiver:} Choose $a=1.5$ if $m<3$ and $a=6.5$ if $m \geq 3$ \\
{\bf Out-of-equilibrium belief:} If $m$ is something other than 0 or 10, then
$t \sim U [0, 3]$ if $m \in [0,3)$ and $t \sim U [3,10]$ if $a \in [3,10]$.
In effect, the Sender has reduced his message space to two messages, LOW (=0)
and HIGH (=10), in Equilibrium 3.
The receiver's optimal strategy in a a partially pooling
equilibrium is to choose his action to equal the expected value of the type in
the interval the sender has chosen. Thus, if $m=0$, the receiver will choose
$a=x/2$ and if $m=10$ he will choose $a = (x+10)/2$.
\newpage
\noindent
{\bf Partial Pooling Equilibrium 3} \\
{\bf Sender:} Send $m=0$ if $t \in [0,3]$ or $m=10$ if $t \in [3,10]$. \\
{\bf Receiver:} Choose $a=1.5$ if $m<3$ and $a=6.5$ if $m \geq 3$ \\
{\bf Out-of-equilibrium belief:} If $m$ is something other than 0 or 10, then
$t \sim U [0, 3]$ if $m \in [0,3)$ and $t \sim U [3,10]$ if $a \in [3,10]$.
The receiver's equilibrium response determines the sender's payoffs from his
two messages. The payoffs between which he chooses are:
\begin{equation} \label{e201}
\begin{array}{ll}
\pi_{sender, m=0} & {\displaystyle = \alpha - \left(\left[t+1 \right]-
\frac{x}{2}\right)^2} \\
& \\
\pi_{sender, m=10}& = {\displaystyle \alpha - \left(\frac {10+x}{2} -\left[t+1
\right]\right)^2}
\end{array}
\end{equation}
There exists a value $x$ such that if $t=x$, the sender is indifferent
between $m=0$ and $m=10$, but if $t$ is lower he prefers $m=0$ and if $t$ is
higher he prefers $m=10$. To find $x$, equate the two payoffs in expression
(\ref{e201}) and simplify to obtain
\begin{equation} \label{e202}
{\displaystyle \left[t+1 \right]- \frac{x}{2}
= \frac {10+x}{2} -\left[t+1 \right]. }
\end{equation}
We set $t=x$ at the point of indifference, and solving for $x$ yields
$x=3$.
\newpage
In the Crawford-Sobel Sender-Receiver Game, the receiver cannot commit to
the way he reacts to the message, so this is not a mechanism design problem.
Nor
is the sender punished for lying, so the unravelling argument for truthtelling
does not apply.
Nor do the players' payoffs depend directly on the message,
which might permit the signalling we will study in Chapter 11 to operate.
Instead, this is a {\bf cheap-talk game}, so called because of these very
absences: $m$ does not affect the payoff directly, the players cannot commit to
future actions, and lying brings no directly penalty.
\newpage
\noindent
{\bf 10.5: Price Discrimination }
Pigou was a contemporary of Keynes at Cambridge who usefully divided
price discrimination into three types in 1920.
\noindent
{\bf 1 Interbuyer Price Discrimination. }
\noindent
{\bf 2 Interquantity Price Discrimination} or {\bf Nonlinear Pricing}.
\noindent
{\bf 3 Perfect Price Discrimination.}
\includegraphics[width=150mm]{fig10-03.jpg}
\begin{center} {\bf Figure 3: Linear and Nonlinear Pricing} \end{center}
\newpage
\begin{center}
{\bf Varian's Nonlinear Pricing Game}
\end{center}
{\bf Players}\\
One seller and one buyer.
\noindent
{\bf The Order of Play }\\
0 Nature assigns the buyer a type, $s$. The buyer is ``unenthusiastic''
with utility function $u$ or ``valuing'' with utility function $v$,
with equal probability. The seller does not observe Nature's move, but the
buyer does. \\
1 The seller offers mechanism $\{ w_m, q_m \}$ under which the buyer can
announce his type as $m$ and buy amount $q_m$ for lump sum $w_m$.\\
2 The buyer chooses a message $m$ or rejects the mechanism entirely and does
not buy at all. \\
\noindent
{\bf Payoffs}\\
The seller has a constant marginal cost of $c$, so his payoff is
\begin{equation} \label{e6a}
w_u + w_v - c \cdot (q_u+q_v).
\end{equation}
The buyers' payoffs are $\pi_u=u (q_u) - w_u$ and $\pi_v=v (q_v) - w_v$ if $q$
is positive, and 0 if $q=0$, with $u', v'>0$ and $u'', v'' <0$. The marginal
willingness to pay is greater for the valuing buyer: for any $q$,
\begin{equation} \label{e7}
u' (q ) < v '(q )
\end{equation}
\newpage
The marginal
willingness to pay is greater for the valuing buyer: for any $q$,
\begin{equation} \label{e7}
u' (q ) < v '(q )
\end{equation}
Condition (\ref{e7}) is an example of {\bf the single-crossing property},
which we will discuss at the end of this section. Combined with the assumption
that $v(0)=u(0) =0$, it also implies that
\begin{equation} \label{e7a}
u (q ) < v (q )
\end{equation}
for any value of $q$.
\newpage
\noindent
{\bf Perfect Price Discrimination}
The game would allow perfect price discrimination if the seller did know
which buyer had which utility function. He can then just maximize profit
subject to the participation constraints for the two buyers:
\begin{equation} \label{e8}
\stackrel{ Maximize}{w_u ,w_v, q_u, q_v} \;\;\; w_u + w_v - c \cdot
(q_u+q_v).
\end{equation}
subject to
\begin{equation} \label{e9}
\begin{array}{ll}
(a) & u (q_u) - w_u \geq 0 \;\; {\rm and} \\
& \\
(b)&v (q_v) - w_v \geq 0.
\end{array}
\end{equation}
The constraints will be satisfied as equalities, since the seller will charge
all that the buyers will pay. Substituting for $w_u$ and $w_v$ into the
maximand, the first order conditions become
\begin{equation} \label{e10}
\begin{array}{ll}
(a) &u' (q_u^*) -c= 0 \;\;\; {\rm and} \\
& \\
(b)&v ' (q_v^*)-c=0.
\end{array}
\end{equation}
Thus, the seller will choose quantities so that each buyer's marginal
utility equals the marginal cost of production, and will choose prices so that
the entire consumer surpluses are eaten up: $w^*(q_u^*) =u (q_u^*)$ and
$w^*(q_v^*) =v (q_v^*)$. Figure 4 shows this for the unenthusiastic buyer.
\includegraphics[width=150mm]{fig10-04.jpg}
\begin{center} {\bf Figure 4: Perfect Price Discrimination} \end{center}
\newpage
\noindent
{\bf Interbuyer Price Discrimination}
\begin{equation} \label{e11}
\stackrel{ Maximize}{q_u,q_v, p_u ,p_v} \;\;\; p_u q_u + p_v q_v - c \cdot
(q_u+q_v),
\end{equation}
subject to the participation constraints
\begin{equation} \label{e12}
\begin{array}{ll}
& u (q_u) - p_u q_u \geq 0 \;\;\; {\rm and} \\
& \\
&v (q_v) - p_v q_v \geq 0
\end{array}
\end{equation}
and the incentive compatibility constraints
\begin{equation} \label{e13}
\begin{array}{ll}
& q_u = argmax [u (q_u) - p_u q_u] \;\;\; {\rm and} \\
& \\
& q_v = argmax [v (q_v) - p_vq_v] .
\end{array}
\end{equation}
This should remind you of moral hazard. It is very like the problem of a
principal designing two incentive contracts for two agents to induce
appropriate effort levels given their different disutilities of effort.
\newpage
\noindent
The agents will solve their quantity choice problems in (\ref{e13}), yielding
\begin{equation} \label{e14}
\begin{array}{ll}
& u' (q_u) - p_u =0 \;\;\; {\rm and} \\
& \\
& v ' (q_v) - p_v=0.
\end{array}
\end{equation}
Thus, we can simplify the original problem in (\ref{e11}) to
\begin{equation} \label{e15}
\stackrel{ Maximize}{q_u,q_v} \;\;\; u'(q_u) q_u + v '(q_v) q_v - c \cdot
(q_u+q_v),
\end{equation}
subject to the participation constraints
\begin{equation} \label{e16}% \label{e10.10}
\begin{array}{ll}
& u (q_u) - u' (q_u) q_u \geq 0\;\;\; {\rm and} \\
& \\
&v (q_v) - v ' (q_v) q_v \geq 0.
\end{array}
\end{equation}
\newpage
The participation constraints will not be binding. If they were, then $ u(q)
/q = u'(q)$, but since $u''<0$ there is diminishing utility of consumption and
the average utility, $U(q)/q$, will be greater than the marginal utility,
$u'(q)$. Thus we can solve problem (\ref{e15}) as if there were no constraints.
The first-order conditions are
\begin{equation} \label{e17}
\begin{array}{ll}
& u''(q_u) q_u + u' =c \;\;\; {\rm and} \\
& \\
&v ''(q_v) q_v+v ' = c.
\end{array}
\end{equation}
This is just the `marginal revenue equals marginal cost' condition that any
monopolist uses, but one for each buyer instead of one for the entire market.
\newpage
\noindent
{\bf Nonlinear Pricing}
\begin{equation} \label{e18}
\stackrel{ Maximize}{q_u,q_v, w_u, w_v} \;\;\; w_u + w_v - c \cdot
(q_u+q_v),
\end{equation}
subject to the participation constraints,
\begin{equation} \label{e19}
\begin{array}{l}
(a)\;\;\;u (q_u) - w_u \geq 0\;\;\; {\rm and} \\ (b)\;\;\;v (q_v) - w_v
\geq 0,
\end{array}
\end{equation}
and the self-selection constraints,
\begin{equation} \label{e20}
\begin{array}{l}
(a) \;\;\; u (q_u) - w_u \geq u (q_v) - w_v \\
\\
(b) \;\;\; v (q_v) - w_v \geq v (q_u) - w_u. \\
\end{array}
\end{equation}
Not all of these constraints will be binding. If neither type had a binding
participation constraint, however, the principal would be losing a chance to
increase his profits. In a mechanism design problem like this, what always
happens is that the contracts are designed so that one type of agent is pushed
down to his reservation utility.
Suppose the optimal contract is in fact separating, and also that both types
accept a contract. At least one type will have a binding participation
constraint. Since the valuing consumer gets more consumer surplus from a given
$w$ and $q$ than an unenthusiastic consumer, it must be the unenthusiastic
consumer who is driven down to zero surplus for $(w_u, q_u)$. The valuing
consumer would get positive surplus from accepting that same contract, so his
participation constraint is not binding. To persuade the valuing consumer to
accept $(w_v, q_v)$ instead, the seller must give him that same positive surplus
from it. The seller will not be any more generous than he has to, though, so the
valuing consumer's self-selection constraint will be binding.
\newpage
\noindent
Rearranging our two binding constraints and setting them out as equalities
yields:
\begin{equation} \label{e21}
w_u =u (q_u)
\end{equation}
and
\begin{equation} \label{e21a}
w_v = w_u- v (q_u) + v (q_v)
\end{equation}
This allows us to reformulate the seller's problem from (\ref{e18}) as
\begin{equation} \label{e22}
\stackrel{Maximize}{q_u,q_v} \;\;\; u(q_u) + u(q_u) -v (q_u) +v (q_v) -
c \cdot (q_u+q_v),
\end{equation}
which has the first-order conditions
\begin{equation} \label{e23}
\begin{array}{ll}
(a) & u'(q_u) - c + [u'(q_u) - v '(q_u)] =0\\
& \\
(b) & v' (q_v) -c =0\\
\end{array}
\end{equation}
\newpage
The first-order conditions in (\ref{e23}) could be solved for exact values
of $q_u$ and $q_v$ if we chose particular functional forms, but they are
illuminating even if we do not. Equation (\ref{e23}b) tells us that the
valuing type of buyer buys a quantity such that his last unit's marginal
utility exactly equals the marginal cost of production; his consumption is at
the efficient level. The unenthusiastic type, however, buys less than his
first-best amount, something we can deduce using the single-crossing property,
assumption (\ref{e7}b), that $u'(q) < v'(q)$, which implies from (\ref{e23}a)
that $u'(q_u) - c >0$ and the unenthusiastic type has not bought enough to
drive his marginal utility down to marginal cost. The intuition is that the
seller must sell less than first-best optimal to the unenthusiastic type so
as not to make that contract too attractive to the valuing type. On the other
hand, making the valuing type's contract more valuable to him actually helps
separation, so $q_v$ is chosen to maximize social surplus.
The single-crossing property has another important implication. Substituting
from first-order condition (\ref{e23}b) into first-order condition (\ref{e23}a)
yields
\begin{equation} \label{e24}% \label{e10.18}
[u'(q_u) - v' (q_v)] + [u'(q_u) - v '(q_u)] =0
\end{equation}
The second term in square brackets is negative by the single- crossing
property. Thus, the first term must be positive. But since the single-crossing
property tells us that $[u'(q_u) - v' (q_u)] <0$, it must be true, since
$v''<0$, that if $q_u \geq q_v$ then $[u'(q_u) - v' (q_v)] <0$ -- that
is, that the first term is negative. We cannot have that without contradiction,
so it must be that $q_u < q_v$. The unenthusiastic buyer buys strictly less
than the valuing buyer. This accords with our intuition, and also lets us know
that the equilibrium is separating, not pooling (though we still have not
proven that the equilibrium involves both players buying a positive amount,
something hard to prove elegantly since one player buying zero would be a
corner solution to our maximization problem).
\newpage
\noindent
{\bf A Graphical Approach to the Same Problem}
Under perfect price discrimination, the seller would charge $w_u= A+B$ and
$w_v = A+B+J+K+L$ to the two buyers for quantities $q_u^*$ and $q_v^*$, as
shown in Figure 5a. An attempt to charge $w_u^* = A+B$ and $w_v^* =
A+B+J+K+L$, however, would simply lead to both buyers choosing to buy $q_u^*$,
which would yield the valuing buyer a payoff of $J+K$ rather than the zero he
would get as a payoff from buying $q_v^*$. The seller's payoff from this pooling
equilibrium (which is the best pooling contract possible for him, since it
drives the unenthusiastic type to a payoff of zero) is $2(A+B)$.
\includegraphics[width=150mm]{fig10-05.jpg}
\begin{center} {\bf Figure 5: The Varian Nonlinear Pricing Game} \end{center}
The seller could separate the two buyers by charging $w_u^* =A+B$ for
$q_u^*$ and $w_v^* =A+B+ L$ for $q_v^*$, since the unenthusiastic buyer
would have no reason to switch to the greater quantity, and that would
increase his profits over pooling by amount $L$.
Figure 5b shows, however, that the seller would do better to slightly reduce
the quantity sold to the unenthusiastic buyer, to below $q_u^*$, and reduce
the price to him by the amount of the dark shading. He could then sell $q_v^*$
to the valuing buyer and raise the price to him by the light shaded area. The
valuing buyer will not be tempted to buy the smaller quantity at the lower
price, and the seller will have gained profit by, loosely speaking, increasing
the size of the $L$ triangle.
\newpage
\includegraphics[width=150mm]{fig10-05.jpg}
\begin{center} {\bf Figure 5: The Varian Nonlinear Pricing Game} \end{center}
Our
profit-maximizing mechanism is shown in Figure 5a as $w_u' = A$ for
$q_u'$ and $w_v^* = A+B+K+L$ for $q_v^*$.
The unenthusiastic buyer is left
with a binding participation constraint and inefficiently low consumption,
because $w_u' = A = u(q_u')$.
The valuing buyer has a nonbinding participation
constraint, because $w_v^* = A+B+K+L < v(q_v^*) = A+B+ J+K+L$; he is left
with a surplus of $J$.
Moreover, he consumes the efficient amount for
him, which is $q_v^*$.
He also has a binding self-selection constraint,
because he is
exactly indifferent between buying $q_u'$ and $q_v^*$.
His choice is between a
payoff of $\pi_v(U) = (A+J)- A$ and $ \pi_v(V) = (A+B+ J+K+L) - (A+B+K+L)$.
Thus, the diagram replicates the algebraic conclusions.
\newpage
\noindent
{\bf The Single-Crossing Property}
When we say that Buyer V's demand is stronger than Buyer U's, however, there
are two things we might mean:
1. Buyer V's {\it average demand} is stronger: $ \frac{v (q )}{q}>\frac{u (q )
}{q} $. Buyer V would pay more for quantity $q$ than Buyer U would.
2. Buyer V's {\it marginal demand} is stronger: $ v' (q )> u' (q )$. Buyer V
would pay more for an additional unit than Buyer U would.
\includegraphics[width=150mm]{fig10-06.jpg}
\begin{center} {\bf Figure 6: Marginal versus Average Demand} \end{center}
Figure 7a depicts functions which satisfy the assumptions of Varian's Nonlinear
Pricing Game: $u = \sqrt{q}$ and $v = 2\sqrt{q}$. The two curves satisfy the
single-crossing property, condition (\ref{e7}), because $v'(q) > u'(q)$ for all
$q$ and $u(0)=0$ and $v(0)=0$.
\includegraphics[width=150mm]{fig10-07.jpg}
\begin{center} {\bf Figure 7: Two Depictions of the Single Crossing Property}
\end{center}
\newpage
Another way to write the payoff functions
would have been as $\pi_u(q, money) = money + u(q)$, where $money = wealth-w(q)
$.
One
comparison is between the curves for which $\pi=10$, which both pass through the
point (0, 10) in $(q, money)$ space.
The $\pi_u=10$ indfference curve then
descends more slowly than the $\pi_v=10$ curve because the commodity is not so
valued by Buyer U.
Another comparison is between the two curves which contain
the point (4,8), which are $\pi_u=10$ and $\pi_v=12$.
These two curves also
cross only once, at that point.
If you pick any one indifference curve
for Buyer U and any one for Buyer V, those curves will cross either not at all,
or once.
\newpage
\noindent
{\bf *10.6 Rate-of-Return Regulation and Government Procurement}
\noindent
The central idea in both government procurement and regulation of natural
monopolies is that the government is trying to induce a private firm to
efficiently provide a good to the public while covering the cost of production.
.
Suppose the government wants
a firm to provide cable television service to a city.
The firm knows more about
its costs before agreeing to accept the franchise (adverse selection),
discovers more after accepting it and beginning operations (moral hazard with
hidden knowledge), and exerts greater or smaller effort to keep costs low
(moral hazard with hidden actions).
The government wants to be generous enough to induce the
firm to accept the franchise in the first place but no more generous than
necessary.
The government
might auction off the right to provide the service,
might allow the firm a
maximum price (a {\bf price cap}),
or might agree to compensate the firm to
varying degrees for different levels of cost ({\bf rate-of- return regulation}).
\newpage
The first version of the model will be one in which the government can observe
the firm's type and so the first-best can be attained.
\begin{center}
{\bf Procurement I: Full Information}
\end{center}
{\bf Players}\\
The government and the firm.
\noindent
{\bf The Order of Play}\\
0 Nature assigns the firm expensive problems with the project, which add
costs of $x$, with probability $\theta$. A firm is thus ``normal'', with type
$N$ and $s=0$, or ``expensive'', with type $X$ and $s=x$. The government
and the firm both observe the type. \\
1 The government offers a contract $\{w(m) = c(m) + p(m), c(m)\}$ which pays
the firm its observed cost $c$ and a profit $p$ if it announces its type to be
$m$ and incurs cost $c(m)$, and pays the firm zero otherwise. \\
2 The firm accepts or rejects the contract.\\
3 If the firm accepts, it chooses effort level $e$, unobserved by the
government. \\
4 The firm finishes the missile at a cost of $c =\bar{c}+ s-e $, which
is observed by the government, plus an additional unobserved cost\footnote{The
reader may ask why this disutility is specified as $f(e- \bar{c})$ rather
than just $f(e)$. The reason is that we will later find an equilibrium cost
level of ($\bar{c}-e^* $), which would be negative if $c_0=0$. }
of $f(e- \bar{c})$. The government reimburses $c(m)$ and pays $p(m)$.
\newpage
\noindent
{\bf Payoffs}\\
Both firm and government are risk-neutral and both receive payoffs of zero if
the firm rejects the contract. If the firm accepts, its payoff is
\begin{eqnarray} \label{e38}% \label{e15.1}
\pi_{firm} & = &p - f(e-\bar{c}) \\
\end{eqnarray}
where $f(e-\bar{c})$, the cost of effort, is increasing and convex, so $f'>0$
and $f''>0$. Assume for technical convenience that $f$ is increasingly
convex, so $f'''>0$.
The government's payoff is
\begin{equation} \label{e39}
\pi_{government} = B - (1+t) c -t p - f,
\end{equation}
where $B$ is the benefit of the missile and $t$ is the deadweight loss from
the taxation needed for government spending. This is substantial. Hausman \&
Poterba (1987) estimate the loss to be around \$0.30 for each \$1 of tax revenue
raised at the margin for the United States.
\newpage
In Procurement I, whether the firm has expensive problems is observed by the
government, which can therefore specify a contract conditioned on the type of
the firm.
The government pays $p_N$ to a normal firm with the cost $c_N$,
$p_X$ to an expensive firm with the cost $c_X$, and $p=0$ to a firm that
does not achieve its appropriate cost level
The expensive firm exerts effort $e= \bar{c}+x-c_X$, achieves $c= c_X$,
generating unobserved effort disutility $f( e-\bar{c}) = f( x - c_X )$,
so its participation constraint, that type $X$'s payoff from reporting that
it is type $X$, is:
\begin{equation} \label{e40}% \label{e15.6}
\begin{array}{lll}
\pi_X(X) &\geq & 0 \\
& & \\
p_X - f( x - c_X ) &\geq & 0. \\
\end{array}
\end{equation}
Similarly, in equilibrium the normal firm exerts effort $e= \bar{c} - c_N$,
so its participation constraint is
\begin{equation} \label{e41}% \label{e15.7}
\begin{array}{lll}
\pi_N(N) &\geq & 0 \\
& & \\
p_N - f( - c_N )& \geq& 0 \\
\end{array}
\end{equation}
The incentive compatibility constraints are trivial here: the government can
use a forcing contract that pays a firm zero if it generates the wrong cost for
its type, since types are observable.
To make a firm's payoff zero and reduce the deadweight loss from taxation, the
government will provide prices that do no more than equal the firm's disutility
of effort. Since there is no uncertainty, we can invert the cost equation and
write it as $e= \bar{c}+x -c $ or $e= \bar{c} -c $. The prices will be
$p_X=f (e-\bar{c})= f (x - c_X)$ and $ p_N=f (e- \bar{c})= f (- c_N ) $.
Suppose the government knows the firm has expensive problems. Substituting the
price $p_X$ into the government's payoff function, equation (\ref{e39}), yields
\begin{equation} \label{e42}% \label{e15.3}
\pi_{government} = B - (1+t) c_X - t f(x-c_X) - f(x - c_X).
\end{equation}
Since $f''>0$, the government's payoff function is concave, and standard
optimization techniques can be used. The first-order condition for $c_X$ is
\begin{equation} \label{e43}
\frac{ \partial \pi_{government}}{\partial c_X} = - (1+t) + (1+t) f'(x -
c_X) = 0,
\end{equation}
so
\begin{equation} \label{e44}
f'(x -c_X) = 1.
\end{equation}
Equation(\ref{e44}) is the crucial efficiency condition for effort. Since the
argument of $f$ is $(e-\bar{c})$, whenever $f'=1$ the effort level is efficient.
At the optimal effort level, the marginal disutility of effort equals the
marginal reduction in cost because of effort. This is the first-best efficient
effort level, which we will denote by $e^*\equiv e:\{ f'(e- \bar{c}) = 1\}$.
If we derived the first-order condition for the normal firm we would find
$f'( -c_N) = 1$ in the same way, so $ c_N = c_X-x $. Also, if the
equilibrium disutility of effort is the same for both firms, then both must
choose the same effort, $e^*$, though the normal firm can reach a lower cost
target with that effort. The cost targets assigned to each firm are $c_X
= \bar{c}+ x - e^*$ and $c_N = \bar{c} - e^*$. Since both types must exert
the same effort, $e^*$, to achieve their different targets, $p_X= f(e^*-
\bar{c}) = p_N$. The two firms exert the same efficient effort level and are
paid the same price to compensate for the disutility of effort. Let us call
this price level $p^*$.
The assumption that $B$ is sufficiently large can now be made more specific: it
is that $B - (1+t)c_X -t f(e^*- \bar{c}) - f(e^*-\bar{c}) \geq 0$, which
requires that $B - (1+t) (\bar{c}+ x - e^*) -(1+t ) p^* \geq 0$. If that
were not true, then the government would not want to build the missile at all if
the firm had an expensive cost function, as we will not treat of here.
\newpage
\noindent
{\bf Procurement II: Incomplete Information (Adverse Selection)}
In the second variant of the game, the existence of expensive problems is
not observed by the government, which must therefore provide incentives for the
firm to volunteer its type if the normal firm is to produce at lower cost
than the firm with expensive problems.
If the government offered the two contracts of Procurement I, both types of
firm would accept the expensive-cost contract, which has a
price of $p^* $ for a cost of $ c=\bar{c}+x - e^*$, enough to compensate the
firm with expensive problems for its effort, and $p= 0$ for any other cost.
That is the cheapest pooling contract, since any contract that paid less would
violate the expensive-cost firm's participation constraint.
It
is inefficient, though, because the normal firm can reduce costs to $ c=\bar{c}
+x - e^*$ by exerting effort lower than $e^*$.
But separating contracts will yield higher welfare than the pooling
contract.
\newpage
A separating contract menu superior to the pooling
contract would be a choice of
(1)
the old pooling contract $(p^*, c=\bar{c}+x - e^*$), OR
(2) a new
contract that offers a slightly higher price $p$ but requires reimbursable
costs $c$ to be slightly lower.
By definition of $e^*$ in first-order
condition (\ref{e44}), $f'(e^*-\bar{c}) =1$, so $f'( e'-\bar{c}) <1$ for the
effort the normal firm exerts in the old pooling contract. If the normal firm
increased its effort from $e'$ by some small amount $\Delta e$, costs would fall
by $(1) \Delta e$ but the firm would only have to be paid $f'( e'-\bar{c})
\Delta e$ more to compensate for its extra disutility. Thus, there is a new
contract that would draw the normal firm away from the old pooling contract and
be preferred by the government.
\newpage
We've shown that there is a pair of separating contracts that the government
likes better than the pooling contract, but not whether that pair is optimal. We
will therefore proceed to find
the optimal pair of contracts ($c_N, p_N)$ ($c_X, p_X$) for firms that
announce $Normal$ or $Expensive$ (with $p=0$ for other cost levels).
Adapting the government's payoff in (\ref{e39}) to the probability $\theta$ of
a expensive firm and probability $1-\theta$ of a normal firm, the government's
maximization problem under incomplete information is
\begin{equation} \label{e49}
\stackrel{ Maximize}{c_N , c_X , p_N, p_X} \;\; \; \theta \left[ B - (1+t)
c_X - t p_X - f( x - c_X ) \right] + \left[ 1- \theta \right] \left[ B -
(1+t) c_N - t p_N- f( - c_N ) \right] .
\end{equation}
A separating contract must satisfy participation constraints and incentive
compatibility constraints for each type of firm. The participation
constraints are the same as in Procurement I: inequalities (\ref{e40}) and
(\ref{e41}):
\begin{equation} \nonumber
\pi_X(X) =
p_X - f( x - c_X ) \geq 0\;\; (\ref{e40})
\end{equation}
and
\begin{equation} \nonumber
\pi_N(N) =
p_N - f( - c_N ) \geq 0 \;\; (\ref{e41})\\
\end{equation}
\noindent
The incentive compatibility constraint for the expensive firm is
\begin{equation} \label{e45}
\pi_X(X) = p_X - f( x - c_X ) \geq \pi_X(N)= p_N - f(x - c_N ),
\end{equation}
and the incentive compatibility constraint for the normal firm is
\begin{equation} \label{e46}% \label{e15.9}
\pi_N(N) = p_N - f( - c_N ) \geq\pi_N(X)= p_X - f( - c_X ).
\end{equation}
Since the normal firm can achieve the same cost level as the expensive
firm with less effort, inequality (\ref{e46}) tells us that if we are to
have $c_N < c_X$, as is necessary for us to have a separating equilibrium, we
need $p_N>p_X$. The second half of inequality (\ref{e46}) must be positive.
If the expensive firm's participation constraint, inequality (\ref{e40}), is
satisfied, then $p_X - f( - c_X )>0$. This, in turn implies that (\ref{e41})
is a strong inequality; the normal firm's participation constraint is
nonbinding.
The expensive firm's participation constraint, (\ref{e40}), will be binding
(and therefore satisfied as an equality), because the government wishes to keep
the price $p$ low to reduce the deadweight loss of extra taxation, the $-
tp_{X}$ term in problem (\ref{e49}). The normal firm's incentive
compatibility constraint must also be binding, because if the pair ($c_N,
p_N$) were strictly more attractive for the normal firm, the government could
reduce the price $p_N$ and save on the $-tp_{N}$ term in problem (\ref{e49}).
Constraint (\ref{e46}) is therefore satisfied as an equality. Knowing that
constraints (\ref{e40}) and (\ref{e46}) are binding, we can write, from
constraint (\ref{e40}),
\begin{equation} \label{e47}
p_X = f( x - c_X )
\end{equation}
and, making use of both (\ref{e40}) and (\ref{e46}),
\begin{equation} \label{e48}
p_N = f ( - c_N ) + f ( x - c_X ) - f ( -c_X ).
\end{equation}
Substituting for $p_X$ and $p_N$ from (\ref{e47}) and (\ref{e48}) into the
maximization problem, (\ref{e49}), reduces the problem to
\begin{equation} \label{e50}
\begin{array}{ll}
\stackrel{ Maximize}{c_N , c_X } & \theta [ B - (1+t) c_X - t f( x -
c_X ) - f( x - c_X ) ] \\
& \\
& + [ 1- \theta ] [ B - (1+t) c_N - t f( - c_N ) - t f( x - c_X ) + t
f( - c_X ) - f( - c_N ) ] . \\
\end{array}
\end{equation}
\noindent
(1) The first-order condition with respect to $c_N $ is
\begin{equation} \label{e51}% \label{e15.14}
(1- \theta) [ - (1+t) + t f'( - c_N ) + f'( - c_N ) ] =0,
\end{equation}
which simplifies to
\begin{equation} \label{e52}
f'( -c_N ) =1.
\end{equation}
Thus, as in Procurement I, $f'_N (e-\bar{c}) =1$. The normal firm
chooses the efficient effort level $e^*$ in equilibrium, and $c_N $ takes the
same value as it did in Procurement I. Equation (\ref{e48}) can be rewritten
as
\begin{equation} \label{e53}
p_N= p^* + f ( x - c_X ) - f( - c_X ).
\end{equation}
Because $ f( x - c_X ) > f( -c_X)$, equation (\ref{e53}) shows that $p_N
> p^*$. Incomplete information increases the price for the normal firm,
which earns more than its reservation utility in the game with incomplete
information. Since the expensive firm will earn exactly zero, this means that
the government is on average providing its supplier with an above-market rate
of return, not because of corruption or political influence, but because that is
the way to induce normal suppliers to reveal that they do not have
expensive problems. This should be kept in mind as an alternative to the
product quality model of Chapter 5 and the efficiency wage model of Section 8.1
for why above-average rates of return persist.
\noindent
(2) The first-order condition with respect to $c_X $ is
\begin{equation} \label{e54}% \label{e15.16}
\begin{array}{l}
\theta \left[ - (1+t) + t f'( x - c_X ) + f'( x - c_X) \right] + \left[
1- \theta \right] [ t f'( x - c_X ) -tf'( - c_X ) ] =0. \\
\end{array}
\end{equation}
This can be rewritten as
\begin{equation} \label{e55}
{\displaystyle f'( x - c_X )=1 - \left(\frac{ 1-\theta}{\theta(1+ t)}
\right) \left[ t f'( x - c_X ) -tf'( - c_X ) \right].}
\end{equation}
Since the right-hand-side of equation (\ref{e55}) is less than one, the
expensive firm has a lower level of $f'$ than the normal firm, and if $f'$ is
lower and $f''>0$, effort must be less than the optimum, $e^*$. Perhaps this
explains the expression ``good enough for government work''-- though our model
can apply to any organization that is trying to buy goods instead of making them
internally. Since, however, the expensive firm's participation constraint,
(\ref{e40}), is satisfied as an equality, it must also be true that $p_X <
p^*$. The expensive firm's price is lower than under full information,
although since its effort is lower its payoff stays the same.
I have not yet said whether the expensive firm's
incentive compatibility constraint was binding. It is not:
the expensive firm is not near being tempted to pick the normal firm's
contract. This is a bit subtle. Setting the left-hand-side of the incentive
compatibility constraint (\ref{e45}) equal to zero because the participation
constraint is binding for the expensive firm, substituting in for $p_N$ from
equation (\ref{e48}) and rearranging yields
\begin{equation} \label{e56}
f( x - c_N )- f( - c_N ) \geq f( x - c_X ) -f( - c_X ).
\end{equation}
As illustrated in Figure 8, inequality (\ref{e56}) is true as a strict
inequality, because $f$ is convex ($f''>0$) and so the increment in $f$'s value
starting frome the lower base $-c_X$ is smaller than starting from $-c_N$.
Thus, the expensive firm's incentive compatibility constraint is nonbinding.
\includegraphics[width=150mm]{fig10-08.jpg}
\begin{center}
{\bf Figure 8: Why the Expensive Firm's Incentive Compatibility Constraint Is
Nonbinding}
\end{center}
To summarize, the government's optimal contract will induce the normal firm
to exert the first-best efficient effort level and achieve the first-best cost
level, but will yield that firm a positive profit. The contract will induce
the expensive firm to exert something less than the first-best effort level
and result in a cost level higher than the first-best, but its profit will be
zero.
There is a tradeoff between the government's two objectives of inducing the
correct amount of effort and minimizing the subsidy to the firm. Even under
complete information, the government cannot provide a subsidy of zero, or the
firms will refuse to build the missile. Under incomplete information, not
only must the subsidies be positive but the normal firm earns {\bf
informational rents}; the government offers a contract that pays the normal firm
more than under complete information to prevent it from mimicking an expensive
firm and choosing an inefficiently low effort. The expensive firm, however,
does choose an inefficiently low effort, because if it were assigned greater
effort it would have to be paid a greater subsidy, which would tempt the normal
firm to imitate it. In equilibrium, the government has compromised by having
some probability of an inefficiently high subsidy ex post, and some
probability of inefficiently low effort.
\newpage
In the last version of the game, the firm's type is not known to either player
until after the contract is agreed upon. The firm, however, learns its type
before it must choose its effort level.
\begin{center}
{\bf Procurement III: Moral Hazard with Hidden Information }
\end{center}
\noindent
{\bf The Order of Play}\\
1 The government offers a contract $\{w(m) = c(m) + p(m), c(m)\}$ which pays
the firm its observed cost $c$ and a profit $p$ if it announces its type to be
$m$ and incurs cost $c(m)$, and pays the firm zero otherwise. \\
2 The firm accepts or rejects the contract.\\
3 Nature assigns the firm expensive problems with the project, which add
costs of $x$, with probability $\theta$. A firm is thus ``normal'', with type
$N$ and $s=0$, or ``expensive'', with type $X$ and $s=x$.
Only the firm observes its type. \\
4 If the firm accepted, it announces its type to be $m$ and chooses
effort level $e$, unobserved by the government. \\
5 If the firm accepted, it finishes the missile at a cost of $c =\bar{c}
+ x-e $ or $c=\bar{c}-e$ which is observed by the government, plus an additional
cost $f(e- \bar{c})$ that the government does not observe. The government
reimburses $c$ and pays $p(c)$.
The government's payoff function is exactly the same as in Procurement II,
equation (\ref{e49})
$$
\stackrel{ Maximize}{c_N , c_X , p_N, p_X} \;\; \; \theta \left[ B - (1+t)
c_X - t p_X - f( x - c_X ) \right] + \left[ 1- \theta \right] \left[ B -
(1+t) c_N - t p_N- f( - c_N ) \right] \;\;\; (\ref{e49}) .
$$
\noindent
The incentive compatibility constraints are exactly the same as in
Procurement II, equations (\ref{e45}) and (\ref{e46}). For the expensive firm the constraint is
\begin{equation} \nonumber
\begin{array}{lll}
\pi_X(X) &\geq & \pi_X(N) \\
& & \\
p_X - f( x - c_X ) &\geq & p_N - f(x - c_N ),\;\;\;\;\;\;\;\;\; (\ref{e45})
\end{array}
\end{equation}
and for the normal firm it is
\begin{equation} \nonumber
\begin{array}{lll}
\pi_N(N) &\geq & \pi_N(X) \\
& & \\
p_N - f( - c_N )& \geq& p_X - f( - c_X ) \;\;\;\;\;\;\;\;\; (\ref{e46})
\end{array}
\end{equation}
The difference from Procurement II is that now there is just one participation
constraint, not two, because the firm does not know its type at the time it
agrees to the contract:
\begin{equation} \label{e57}% \label{e15.6z}
\theta[ p_X - f( x - c_X ) ] + [1-\theta][ p_N - f( - c_N )] \geq 0.
\end{equation}
Thus, the maximization problem is less constrained in Procurement III. The two
participation constraints of Procurement II jointly imply constraint
(\ref{e57}) is satisfied, but the reverse is not true. Now, the payoff of the
expensive type can be negative, so long as the payoff of the normal type is
positive enough to make the overall payoff non-negative.
The participation constraint, inequality (\ref{e57}), will be binding,
because the government wants to keep the deadweight loss from taxation low, and
it can now make the expensive firm's payoff negative enough to compensate
for the normal firm's positive payoff. So long as the overall expected payoff
is zero, the firm will still agree to the contract. There is no informational
rent ex ante, unlike in Procurement II.
The normal firm's incentive compatibility constraint will still be binding.
That firm does not want to admit that it can reduce costs easily, so it has a
strong incentive to imitate the expensive firm, and must be bribed not to. The
government will not want to pay a bigger bribe than necessary.
If the pair ($c_N, p_N$) were strictly more attractive for the normal firm
than ($c_X, p_X$), the government could reduce the price $p_N$. Constraint
(\ref{e46}) is therefore satisfied as an equality.
\noindent
Knowing that constraints (\ref{e46}) and (\ref{e57}) are binding, we can
write from constraint (\ref{e57}),
\begin{equation} \label{e59}
p_X = f( x - c_X ) - \frac{ [1-\theta][ p_N - f( - c_N )] }{\theta}.
\end{equation}
Substituting from (\ref{e59}) for $p_X$ into (\ref{e46}), we get
\begin{equation} \label{e60}
p_N -f ( - c_N ) = f( x - c_X ) - \frac{ [1-\theta][ p_N - f( - c_N )]
}{\theta} - f ( - c_X ). \end{equation}
This can be solved for $p_N$ to yield
\begin{equation} \label{e61}
p_N = \theta [f(x-c_X) - f( -c_X)] + f(- c_N ),
\end{equation}
which when substituted into (\ref{e59}) yields
\begin{equation} \label{e62}
p_X = [1-\theta] [f(x-c_X) - f( -c_X)].
\end{equation}
Substituting for $p_N$ and $p_X$ from (\ref{e61}) and (\ref{e62}) into the
maximization problem reduces the problem to
\begin{equation} \label{e64}% \label{e15.13z}
\begin{array}{ll}
\stackrel{ Maximize}{c_N , c_X } & \theta \left\{ B - (1+t) c_X - t
[1-\theta] [f(x-c_X) - f( -c_X)] - f( x - c_X ) \right\} \\
& + \left[ 1- \theta \right] \left[ B - (1+t) c_N - t \{ \theta [f(x-c_X) -
f( -c_X)] + f(- c_N ) \}- f( - c_N ) \right] .\\
& \\
\end{array}
\end{equation}
\noindent
The first-order condition with respect to $c_N $ is
\begin{equation} \label{e65}% \label{e15.14z}
(1- \theta) [ - (1+t) + t f'( - c_N ) + f'( - c_N ) ] =0,
\end{equation}
just as under adverse selection, which simplifies to
\begin{equation} \label{e66}% {e15.15z}
f'( -c_N ) =1.
\end{equation}
Thus, the crucial efficiency condition (\ref{e44}) is satisfied: $f'(e -
c_0) =1$. The normal firm chooses the efficient effort level $e^*$ in
equilibrium, and $c_N $ takes the same value as it did in Procurement I and
II.
Now that we know that the effort level is $e^*$, we can say something about the
normal firm's payoff.
Since $ p^* = f(- c_N )$, the optimal price equation (\ref{e61}) can be
rewritten as
\begin{equation} \label{e67}
p_N = \theta [f(x-c_X) - f( -c_X)] + p^* ,
\end{equation}
Because $ f( x - c_X ) > f( -c_X)$, equation (\ref{e67}) shows that $p_N
> p^*$, even though $e_N=e^*$. The normal firm earns a positive payoff even
though information was symmetric at the start of the game. It earns an
informational rent because partway through the game it learns its type and the
government does not, and the government needs to pay something to induce it to
admit to its low-cost type.
The expensive firm must earn less than its reservation utility so that the
overall participation constraint will be satisfied as an equality.
The government could have made the expensive firm's payoff negative in
either of two ways: (a) a lower $p_X$ than in Procurement II, or (b) a lower
$c_X$ than in Procurement II (and thus higher $e_X$). Option (b) is what we
just derived. It is beter than (a) because it raises the expensive firm's
effort to closer to the efficient level. This increases the amount of surplus,
and the government will get the entire surplus since there is now no
informational rent. Hence, the expensive firm's effort is higher in
Procurement III than in Procurement II.
Now that $c_X$ is higher for the same $p_X$, the expensive cost-price
pair is less attractive than in Procurement II. As a result, $\pi_N(X)$ is
lower, and the government can make the normal firm's cost-price pair less
attractive too. This is we found that though $c_N$ is unchanged from
Procurement II, $p_N$ has fallen.
To summarize, the government's optimal contract in Procurement III will induce
the normal firm to exert the first-best efficient effort level and achieve
the first-best cost level, but will yield that firm a positive payoff, though
smaller than in Procurement II. The contract will induce the expensive firm
to exert less than the first-best effort level, though more than in
Procurement II, and result in a cost level higher than the first-best and a
negative payoff. Overall, the firm's expected payoff will be zero.
This is what one might expect of moral hazard with hidden information as
compared to adverse selection. Starting with symmetric information results in
less gaming at the time of contract formation, so the principal's maximization
problem has three constraints to satisfy instead of four, and this results in
effort choices closer to the first-best. Effort choices still do not always
reach the first-best, however, because information about player types does
become asymmetric midway through the game, and the contract has to be designed
to induce the informed player, the firm, to disclose its information.
A practical implication is that the parties ought to agree on a contract as
early as possible in the procurement process, before one of them acquires an
informational advantage. Of course, this does not apply if one of them {\it
starts} with an informational advantage; then, delay before agreement might
actually help, by giving the uninformed party time to learn the facts it needs.
\end{LARGE}
\end{document}