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Tuesday, September 28, 2021 at 4:15pm to 5:15pm
Uris Hall, 498
Hector Chade, Arizona State University
Disentangling Moral Hazard and Adverse Selection (joint w/Jeroen Swinkels)
Abstract: We analyze a canonical principal-agent problem with both moral hazard and adverse selection. We provide a method of solution, decoupling, which consists of first minimizing the principal’s cost of implementing any given action at any given surplus for any given type in a relaxed moral-hazard problem, then using the resulting cost function as an input to a pure adverse-selection problem, and finally substituting back in the optimal compensation schemes from the moral-hazard problem. We show broad settings where the solution to this radically simplified and highly tractable program is optimal in the full problem. Decoupling has powerful implications for the structure of optimal menus. We illustrate our results in the context of an insurance market, and show how to extend our results to a social planner, and to a setting with common values.