In the optimal principal-agent contract, why does the principal distort the low-ability agent's contract away from first-best efficiency, even though this reduces total surplus?
ATo make the low-ability agent's contract unattractive enough that the high-ability agent will not want to mimic it, reducing the information rent the principal must pay the high type
BTo punish the low-ability agent for being less productive and reduce moral hazard
CBecause the participation constraint for the low type is harder to satisfy with an efficient contract
DTo satisfy the incentive compatibility constraint of the low type, who would otherwise prefer the high-type contract
The distortion serves one purpose: to deter mimicry by the high type. If the low-type contract were efficient (first-best), the high type would happily accept it and claim to be low ability while enjoying better terms. By making the low-type contract sufficiently unattractive — lower pay, less responsibility — the principal ensures the high type prefers her own contract. The cost is deadweight loss on low-type trades, but it reduces the information rent paid to the high type.
Question 2 Multiple Choice
What does the 'no distortion at the top' result mean in optimal contract design?
AThe highest-ability agent receives an efficient (first-best) contract with no distortion, though she earns an information rent above her outside option
BThe highest-ability agent's contract is not distorted because she faces no moral hazard problem
CThe principal never distorts any contract because doing so always reduces her profit
DThe high-ability agent receives a contract that exactly equals her outside option with no surplus
In the optimal menu, the high type's contract specifies the first-best efficient effort level — there is no distortion of her actions. However, she earns a positive information rent (surplus above her outside option). The distortion occurs only in the low type's contract, which is less efficient than first-best. This 'no distortion at the top' pattern is a central result of mechanism design and screening theory.
Question 3 True / False
In the optimal principal-agent solution, the high-ability agent earns strictly more than her outside option (her reservation utility).
TTrue
FFalse
Answer: True
True. This excess surplus is the information rent — the unavoidable payment the principal makes to the high type for truthfully revealing her type. If the principal tried to leave the high type with exactly her outside option, the high type would prefer to mimic the low type's contract and earn a better deal. The rent is the minimum bribe needed to make self-selection incentive compatible.
Question 4 True / False
A principal can generally achieve the first-best outcome by offering a single contract that ties most compensation purely to observed output, eliminating any need for menus or information rents.
TTrue
FFalse
Answer: False
False. Pure output-based contracts face two problems: (1) they expose risk-averse agents to income risk, violating the participation constraint or requiring a risk premium that is costly to the principal; (2) they cannot separate types — a single contract cannot simultaneously satisfy both the high type's and low type's incentive compatibility constraints if the principal does not know which type is which. Menus of contracts and information rents are necessary features of second-best optimal contracting, not avoidable inefficiencies.
Question 5 Short Answer
Why are information rents unavoidable in the principal-agent problem with adverse selection? What happens if the principal tries to design contracts that leave the high-ability agent with exactly her outside option?
Think about your answer, then reveal below.
Model answer: If the high-ability agent is left with exactly her outside option, she prefers to mimic the low-ability agent's contract — which, if designed for a less capable agent, would still give the high type more than her outside option given her higher ability. To prevent this mimicry, the principal must make the high type's own contract sufficiently attractive, leaving her with surplus (the information rent). Eliminating the rent by reducing the high type's contract makes it less attractive than the low type's, so the high type defects. The rent is the minimum payment required to make truthful self-selection incentive compatible.
The information rent arises from the participation constraint of the high type plus the incentive compatibility constraint. The principal must satisfy both simultaneously: the high type must prefer to participate (PC) and must prefer her own contract over the low type's (IC). These constraints jointly require strictly positive surplus for the high type. This is a fundamental constraint of mechanism design under asymmetric information — not a failure of contract design.