Optimal Contracts for Agents with Adverse Selection

Abstract

Due to information asymmetry, adverse selection exists largely in the multiagent market. Aiming at these problems, we develop two models: pure adverse selection model and mixed adverse selection and moral hazard model. We make the assumption that a type of agent is discrete and effort level is continuous in the models. With these models, we investigate the characters that make an optimal contract as well as the conditions under which the utility of a principal and agents can be optimized. As a result, we show that, in the pure adverse selection model, the conditions to reach the optimal utility of a principal and individual agents are that a principal needs to design different contracts for different types of agents, and an individual agent chooses the corresponding type of contracts. For the mixed model, we show that incentive constraint for agents plays a very important role. In fact, we find that whether a principal provides high-type contract or a separating equilibrium contract depends on the probability of existence of low-type agents in the market. In general, if a separating equilibrium contract is issued, then information asymmetry will cause the utility of the high-type agents to be less than that of the case in full information.