Problem Set 4: Adverse selection, moral hazard, and principal-agent problems

1. High productivity workers produce 2,000,000 worth of goods over their lifetime (in present value terms), whereas low productivity workers only produce 500,000 worth in their lifetime. 20% of all workers are high productivity, but an employer is unable to tell to which group a given worker belongs (even after they have worked for them for a lifetime). It costs high productivity workers 100,000 in disutility to successfully complete a year in higher education, while it costs low productivity workers 300,000 to do the same thing (as it takes them longer to do the problem sets). Assume that people can stay in higher education for as long as they wish, and that people who leave education later both retire later and die later, so the number of years they spend in education has no impact on how many years they work in total (or how many years of retirement they get). a) Will there be a separating and/or pooling equilibrium in this market? How many years of higher education will high and low types complete in the equilibria that you find? b) A possible implication of this model is that education is a socially wasteful activity. Explain why. Do you agree?

2. There are two types of people wishing to buy flowers: business people and young couples. Suppose there are equal numbers of people in both groups. Business people value flowers at 5 + 4 where = 1 if they are able to pick up the flowers in the train station on the way home from work and = 0 if they have to buy them online. Young couples value flowers at 4 + 2. Suppose that there is an infinite supply of flowers both at the train station and online, and that they can be produced at zero cost to the flower seller (a monopolist). Given the flower seller cannot tell whether someone is a business person when they buy their flowers, what price should they set for flowers at the train station and flowers on the internet?

3. [Very trickytoo hard for an exam, dont worry!] There are two possible states of the world, good and bad. In the good state of the world, individuals get an income of , and in the bad state they get an income of , where < . The probability of the bad state of the world is max{0,1 } where is the amount of effort agents expend in trying to avoid it (and is some constant). Individuals seek to insure themselves against the bad state of the world by purchasing insurance at the actuarially fair premium (i.e. = max{0,1 }) from the insurer. Individuals are risk averse with vNM utility function (, ) = ( )2 , where is some constant. The insurer is wise to the problems caused by moral hazard however, and prevents anyone from taking out more than ( ) units of insurance, where is some constant between 0 and 1. Show that in an internal solution, individuals will purchase ( ) units of insurance. Thus solve for their effort levels in an internal solution. Now suppose that the insurer seeks to choose to maximise the amount of insurance purchased (perhaps the insurer can sell a secondary good to people purchasing insurance from them). What level of will they choose, when = 2 , = 1 , = 2 and = 2 ? [Hint: find the highest level that is consistent with your solution for being valid.]

4. An owner wishes to incentivise his risk neutral manager. The manager attends for a full working week, but the hours of effort he puts in are unobservable to the owner. The cost of each hours effort for the manager is equivalent to 20. Profits are maximised where output is 1000, which is achieved when the manager puts in 25 hours of effort. The manager has an outside option that enables him to earn 200 and put in zero hours of effort. a) What is the best compensation scheme from the owners point of view? b) Why is the optimal incentive scheme that you have identified relatively uncommon in the real world?

5. [Slightly tricky] An agent has mean-variance utility given by = ( )2 2 2 , where is their risky income, is their unobserved effort level, measures their risk aversion, and measures their cost of effort. They have an outside option which delivers a utility of with certainty. A risk-neutral principal wishes to maximise () , where () is their risky profits, which is normally distributed with mean and variance . The principal is constrained to only offer linear contracts to the agent, of the form = + () . Prove that the optimal choice of is only a function of and , not a function of or . Show that when = 0, = 1. Verify that when = 1, 0.3660254040, by substitution.

6. a) To what extent does the NHS solve the inefficiencies caused by asymmetric information in private health care markets? b) Provide an economists perspective on the incentive problems that a system like the NHS might face instead.