An Introduction to the Economics of Information
Summary
Macho-Stadler and Perez-Castrillo wrote a graduate textbook on the economics of information, covering the standard models of contracting under asymmetric information.
The organisation follows the field's three central problems. Moral hazard arises when one party takes an action the other cannot observe, so the contract must be written on observable outcomes that imperfectly reflect the action. The authors develop the principal-agent model, derive the optimal contract under risk aversion, and show the trade-off between insurance and incentives: a risk-averse agent should be insured against outcomes they cannot control, but insurance removes the incentive to act, so the optimal contract exposes the agent to some risk purely to motivate effort.
Adverse selection arises when one party knows something relevant before contracting. The authors develop the screening model in which the uninformed party offers a menu of contracts designed so that each type of counterparty selects the one intended for it, and derive the standard results: the most efficient type receives an information rent, and the contracts offered to less efficient types are distorted away from efficiency to make the sorting work.
Signalling covers the case where the informed party moves first, taking a costly action that credibly conveys their type because it would be more costly for a different type to imitate.
They also cover mechanism design and the revelation principle, moral hazard with multiple agents including tournaments and team production, and repeated relationships.
The book is a technical textbook requiring microeconomics and mathematics. It teaches the models rather than their applications, so readers wanting to see the theory applied to contracting or organisational design must make the translation themselves. The models underpin most modern thinking about incentives, insurance, corporate governance and market design.
Key takeaways 7
- When effort cannot be observed, a contract must be written on outcomes, which forces a trade-off between insuring the agent and motivating them.
- An optimal incentive contract deliberately exposes a risk-averse agent to risk they cannot control, purely to induce effort.
- A party with private information about their own type earns an information rent that the uninformed party cannot recover.
- Offering a menu of contracts designed so each type self-selects is the standard response to adverse selection.
- Contracts offered to less efficient types are distorted away from efficiency to make the sorting mechanism work.
- A signal conveys information credibly only when it would be more costly for a different type to send it.
- Relative performance evaluation across agents filters out common shocks and improves the information content of an outcome measure.
Who should read it
Readers with economics training who need the formal models underlying incentive design, contracting and market mechanisms.
Similar books 6
Chosen by shared topics, the entries that hold them, and the people who recommended both.
How firms are organised, using agency, contracts and transaction-cost economics.
Antitrust should rest on the economics of efficiency, not on protecting competitors.
Recommended by: Mohnish Pabrai
The economic criteria for setting regulated utility rates.
Where it sits in the reference 2
Topics