A standard hidden information model is considered to study the influence of the a priori productivity distribution on the optimal contract. A priori more productive (hazard rate dominant) agents work less, enjoy lower rents, but generate a higher expected surplus.adverse selection, statistical discrimination, stochastic order relation

Wendelin Schnedler

English

Research Papers in Economics

Bonn Econ Discussion Papers
Discussion Paper 18/2001
The Virtue of Being Underestimated: A Note on
Discriminatory Contracts in Hidden Information
Models
by
Wendelin Schnedler
June 2001
Bonn Graduate School of Economics
Department of Economics
University of Bonn
Adenauerallee 24 - 42
D-53113 Bonn                                     The Bonn Graduate School of  Economics is
                                                             sponsored by theThe Virtue of Being Underestimated:
A Note on Discriminatory Contracts
in Hidden Information Models
Wendelin Schnedler∗
First Version: September 1999
This Version: June 2001
Abstract
A standard hidden information model is considered to study the inﬂuence
of the a priori productivity distribution on the optimal contract. A priori
more productive (hazard rate dominant) agents work less, enjoy lower
rents, but generate a higher expected surplus.
JEL Classiﬁcation: D82 J71
keywords: adverse selection, statistical discrimination, stochastic order relation
1 Introduction
In the standard hidden information model which is described in many contract
and game theory textbooks (Fudenberg and Tirole 1991, Salani´ e 1998, Schweizer
2000) and has been applied in many ways (see e.g. Melumand, Mookherjee, and
Reichelstein 1995), a principal (e.g. an employer) oﬀers an agent (e.g. a worker)
a menu of work loads trying to elicit the latter’s productivity. When designing
the menu, the principal will rely on an a priori distribution of productivity.
This distribution can be interpretated as the beliefs held by the employer about
the productivity of the worker or as the distribution of productivity in a pop-
ulation from which the worker is randomly drawn. A diﬀerence in the a priori
distribution for otherwise identically productive workers may lead to a diﬀerent
treatment of workers – an eﬀect which is known as statistical discrimination and
has ﬁrstly been described by Phelps (1973); for a recent overview see Altonji
and Blank (1999).
Since statistical discrimination is based on the idea that workers cannot credibly
signal their productivity so that employers have to rely on a priori distributions,
the hidden information model constitutes a natural framework to study statis-
tical discrimination. While the role of a priori distributions has been analysed
for the hidden action model (Robbins and Sarath 1998), a similar task has not
yet been accomplished for the hidden information model.
∗Bonn Graduate School of Economics, Department of Economics, University of Bonn
and Institute for the Study of Labor, IZA, P.O. Box 7240, D-53072 Bonn, Germany
The author wants to thank Georg N¨ oldecke, Urs Schweizer, and Stefan Napel for
helpful comments. Financial support by DFG and IZA is gratefully acknowledged.
1This note ﬁlls the gap by studying how a priori distributions aﬀect three im-
portant variables of the hidden information model: expected proﬁt accrueing to
the principal, work loads assigned to and informational rents enjoyed by workers
of a given productivity. To establish whether these variables are increasing or
decreasing in the a priori distribution, we must be able to order distributions in
some way. Then, we can make monotonicity statements based on two types of
agents with orderable a priori distributions.
Suppose the employer observes a particular characteristic of the worker before
proposing a menu of work loads; say workers can be red or blue. Assume that
for some reason the productivity of blue agents is stochastically larger in a
particular sense which we will deﬁne later, i.e. blue agents are a priori more
productive. Then, one might be tempted to conclude that blue workers will
be preferably hired, asked to work more, and be better paid than red workers.
Indeed, it turns out that hiring a blue agent maximises the expected proﬁt of
the principal, but with respect to work loads and pay the intuition turns out
to be false: if being hired, red agents of a given productivity get assigned more
work and are better oﬀ than blue agents of the same productivity.
The results can be motivated as follows: in order to convince an agent to reveal
his true productivity, the principal has to pay an informational rent. This
rent rises in the productivity of an agent and it increases in the work loads of
agents with a lower productivity. Since there are more blue agents with a high
productivity, costs of paying them their informational rents are higher than for
red agents. To reduce these costs the principal chooses lower work loads for blue
agents. Section 2 presencts the main ﬁndings and section 3 concludes.
2 Hazard rate dominance and discrimination
Consider a risk neutral principal and a risk neutral agent of colour i ∈{ R,B}
and productivity θ.L e tB(a) the concave beneﬁt function of the principal and
c(a,θ) be the cost function of the agent when carrying out assignment a,w h e r e
the costs are strictly convex in a, falling in θ, and independent of the colour.
Suppose that agents have quasi linear utilities and an outside option normalised
to zero.
Now, the contract which maximises the principal’s expected proﬁt should be
determined. By the revelation principle, it suﬃces to restrict attention to truth
revealing contracts. Hence, we are looking for a direct mechanism prescribing
the work assignment ai(θ) and wage xi(θ) for a worker of colour i who has
productivity θ which solves the following maximisation problem:
max(ai(θ),xi(θ))EΘi [B(ai(Θi)) − xi(Θi)] (1)
such that θi ∈ argmaxθ xi(θ) − c(ai(θ),θ)( 2 )
and xi(θ) − c(i(θ),θ) ≥ 0 ∀θ ∈

θ,θ

, (3)
where EΘi(·) is the expected value operator applied over the random variable
Θi describing the a priori productivity of an agent of colour i. Condition (2)
ensures that all agents are willing to disclose their true productivity while con-
2dition (3) guarantees the participation of agents of all productivities.
In order to apply the machinery of the classical hidden information or adverse
selection model, we suppose the single crossing property
∂2
∂a∂θ
c(a,θ) < 0, (4)
and the following set of standard assumptions (Fudenberg and Tirole 1991, A8
on p. 263 and A10 on p. 267):
∂3
∂a2∂θ
c(a,θ) < 0,
∂3
∂a∂θ2c(a,θ) > 0,
∂
∂θ
1 − Fi(θ)
fi(θ)
< 0. (5)
Under these assumptions, the solution to the problem deﬁned by (1) to (3) is
identical to the solution of the following simpler maximisation problem (Fuden-
berg and Tirole 1991, p. 265):
max
ai(θ)
B(ai(θ)) −

c(ai(θ),θ) −
1 − Fi(θ)
fi(θ)
∂
∂θ
c(ai(θ),θ)

  
=:h(ai(θ),θ)
. (6)
The term h(ai(θ),θ) does not only contain a component to compensate for the
exerted eﬀort but also reﬂects the cost of eliciting the true productivity of the
agent and is often referred to as virtual cost (see e.g. Salani´ e 1998).
The standard assumptions (4) and (5) also ensure that the objective function
in (6) is concave, hence the solution to (6) can be obtained by the ﬁrst order
condition:
∂
∂a
B(a∗
i(θ)) −
∂
∂a
c(a∗
i(θ),θ)+
1 − Fi(θ)
fi(θ)
∂2
∂a∂θ
c(a∗
i(θ),θ)
! =0 . (7)
Next, we relate the productivity distributions of blue and red agents by declaring
the a priori distribution of blue agents to hazard rate dominate the a priori
distribution of red agents, if and only if
fB(θ)
1 − FB(θ)
<
fR(θ)
1 − FR(θ)
∀ θ ∈

θ;θ

, (8)
where

θ;θ

is the open subset of the common support of both distributions.
Intuitively, hazard rate dominance means the following: knowing that an agent
has a productivity above θ, the probability of encountering a red agent of a
productivity in a tiny interval above θ is larger than the probability of encoun-
tering a blue agent. For this to be true, the distribution of blue agents must
have relatively more probability mass to the right. Hence, it is justiﬁed to call
blue agents “a priori more productive”.
As an illustration of hazard rate dominance consider the following example: blue
agents’ productivity is uniformly distributed between zero and one while the cu-
mulative distribution function of red agents’ is FR(θ)=θ(2 − θ) ∀θ ∈ [0,1].
30
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
.01
.08
.15
.22
.29
.36
.43
0.5
.57
.64
.71
.78
.85
.92
.99
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
01
08
15
22
29
36
43
0.5
57
64
71
78
85
92
99
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0.01
0.08
0.15
0.22
0.29
0.36
0.43
0.5
0.57
0.64
0.71
0.78
0.85
0.92
0.99
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
0.01
0.08
0.15
0.22
0.29
0.36
0.43
0.5
0.57
0.64
0.71
0.78
0.85
0.92
0.99
         Cumulative                        Densities 
     Distributions 
blue agents                           blue agents 
red agents                             red agents 
Figure 1: Distributions and Densities
The respective densities and distributions are depicted in ﬁgure 1.
In this example, blue agents’ productivity also ﬁrst order stochastic dominates
red agents’ productivity, which raises the question, how hazard rate dominance
relates to ﬁrst order stochastic dominance. A simple answer is given by the
following result.
Result 1. If fB(·) and fR(·) are continuous and FB(θ) hazard rate dominates
FR(θ) then FB(θ) ﬁrst order stochastically dominates FR(θ).
Proof. See appendix.
Like ﬁrst order stochastic dominance, hazard rate dominance induces no com-
plete ordering of distributions; as it is a stronger concept, the class of distri-
bution pairs which can be ordered is even smaller. For an alternative proof of
Result 1 and an elaborate overview on stochastic orders, the reader may consult
M¨ uller and Stoyan (forthcoming).
Now, we will use the notion of hazard rate dominance to make a statement about
work assignment diﬀerences between blue and red agents. By considering the
maximisation problem expressed as (6), we observe that hazard rate dominance
directly leads to lower virtual costs for the dominated type at all productivities.
Since the converse is also true, hazard rate dominance turns out to be a necessary
and suﬃcient condition for lower optimal production assignments:
Result 2. Given assumptions (4) and (5), the optimal production assignment
a∗
B(θ) is lower than a∗
R(θ) for all θ ∈

θ,θ

if and only if FB(·) hazard rate
dominates FR(·).
Proof. By (4) and (5), it follows that (6) is uniquely maximised in a∗
R and
a∗
B for the respective a priori distributions. Adding the inequalities describing
these maximum properties, we get:
	
1−FR(θ)
fR(θ) −
1−FB(θ)
fB(θ)


·

− ∂
∂θc(a∗
R(θ),θ)

>
	
1−FR(θ)
fR(θ) −
1−FB(θ)
fB(θ)


·

− ∂
∂θc(a∗
B(θ),θ)

. Given (4), the second factor is increas-
ing in a. Hazard rate dominance implies that the ﬁrst factor is positive, so that
4a∗
R >a ∗
B.C o n v e r s e l y ,a∗
R >a ∗
B implies that the second factor on the right hand
side is smaller than that on the left, so that the ﬁrst factor must be positive.
In general, the payment xi to an agent of colour i consists of two elements:
a compensation for the eﬀort costs and an informational rent. The functional
form of the payment looks as follows (Salani´ e 1998, p.34):
xi(θ)= c(a∗
i(θ),θ)
  
compensation
−
 θ
θ
∂
∂θ
c(a∗
i(t),t)dt
  
informational rent
. (9)
Since eﬀort costs and compensation cancel, utility between agents of diﬀerent
colour only diﬀers with respect to informational rents. By the single crossing
property (4), the integrand in the informational rent term (9) gets smaller when
the assignment a increases; minus the integrand gets larger and so does the
informational rent which is the integral over these terms. By result 2 red agents
get larger assignments and we can state:
Corollary 1. Given assumptions (4) and (5), a red agent of productivity θ
enjoys a higher utility than a blue agent of the same productivity for all θ ∈

θ,θ

if and only if FB(·) hazard rate dominates FR(·).
Proof. Red agents enjoy higher utility iﬀ for all θ ∈

θ,θ

: xR(θ)−c(a∗
R(θ),θ) >
xB(θ)−c(a∗
B(θ),θ) ⇔∀ θ ∈

θ,θ

:
 θ
θ − ∂
∂θc(a∗
R(t),t)dt >
 θ
θ − ∂
∂θc(a∗
B(t),t)dt ⇔
∀θ ∈

θ,θ

: − ∂
∂θc(a∗
R(t),t) > − ∂
∂θc(a∗
B(t),t) ⇔∀ θ ∈

θ,θ

: a∗
R(θ) >a ∗
B(θ)
where the latter is true by Result 2 iﬀ blue hazard rate dominates red.
Finally, we want to answer the question what colour the principal prefers.
Result 3. Given assumptions (4) to (5) and that FB(·) hazard rate dominates
FR(·), blue agents generate a higher expected proﬁt.
Proof. Denote the proﬁt generated by the agent of productivity θ carrying out
assignment a by π(a,θ). Note, that the constraints (3) and (2) are independent
from the distribution, so that assigning a∗
R(θ) to blue agents does not violate
those constraints. As this assignment is not optimal, we get: EB [π (a∗
B(θ),θ)] >
EB [π (a∗
R(θ),θ)]. If proﬁts are increasing in θ, hazard rate dominance implies
EB [π (a∗
R(θ),θ)] > ER [π (a∗
R(θ),θ)] and we are done. To show that proﬁts
increase in θ,w et a k et h e i rd e r i v a t i v e :
	
∂B(a
∗
i (θ))
∂a −
∂c(a
∗
i (θ),θ)
∂ai


∂ai(θ)
∂θ > 0, where
the ﬁrst factor is positive by (7) and the second factor is positive due to the
strict concavity implied by (4) and (5) and the fact that for incentive compatible
mechanisms assignments must be increasing in productivity (Salani´ e, p. 31).
The assumptions in this result can be considerably relaxed (see appendix); here,
it is presented in a less general but more coherent version.
3C o n c l u s i o n
We examined two distinctive types of agents who only diﬀered with respect to
their a priori distribution of productivity. Ranking these distributions so that
5one type is a priori more productive according to a relation called hazard rate
dominance enabled us to establish a link between a priori productivity and three
important variables in the hidden information model: expected proﬁt, work as-
signments, and informational rents.
Not surprisingly, the principal prefers a priori more productive agents. If, how-
ever, agents with a lower a priori productivity are employed, they get larger
work assignements than their a priori more productive homologues and enjoy
higher informational rents. In this sense, being underestimated is advantagous.
References
Altonji, J. G., and R. Blank (1999): “Race and Gender in the Labor Mar-
ket,” in Handbook of Labor Economics, ed. by O. Ashenfelter, and D. Card,
vol. 3, pp. 3143–3259. Elsevier B.V., Amsterdam.
Fudenberg, D., and J. Tirole (1991): Game Theory. The MIT Press, Cam-
bridge, Massachusetts.
Melumad, N. D., D. Mookherjee, and S. Reichelstein (1995): “Hierar-
chical Decentralization of Incentive Contracts,” RAND Journal of Economics,
26(4), 654–672.
M¨ uller, A., and D. Stoyan (forthcoming): “Univariate Stochastic Order
Relations,” ”Comparison Methods for Stochastic Models and Risks”, John
Wiley and Sons, forthcoming.
Phelps, E. S. (1973): “The Statistical Theory of Racism and Sexism,” Amer-
ican Economic Review, 62(4), 659–661.
Robbins, E. H., and B. Sarath (1998): “Ranking Agencies Under Moral
Hazard,” Economic Theory, 11(1), 129–155.
Salani´ e, B. (1998): Economics of contracts.M I TP r e s s .
Schweizer, U. (2000): ¨ Okonomische Theorie der Vertr¨ age. Mohr (Siebeck),
T¨ ubingen.
Appendix
The following lemma is needed to proof Result 1.
Lemma 1. If fR(·) and fB(·) are continuous density functions with the same
support, then there exists a ˜ θ ∈

θ,θ

such that fR(˜ θ)=fB(˜ θ).
Proof. Suppose that ˜ θ would not exist, then fR(θ) >f B(θ) ∀θ ∈

θ,θ

without
loss of generality. Integrating over the whole support, we get

Ω fR(t)dt > 
Ω fB(t)dt =1 , where the inequality is a contradiction to the claim of fR(·)
being a density function.
6Proof of Result 1
We want to show that hazard rate dominance implies ﬁrst order stochastic
dominance. The proof will be carried out in two steps. First, we will show
that FR(θ) is larger than FB(θ) for small θ, afterwards we prove that FR(·)a n d
FB(·) can never intersect.
Step 1
By lemma 1, exists a ˜ θ ∈

θ,θ

, such that 0 <f R(˜ θ)=fB(˜ θ). Pick the smallest
such ˜ θ. Using the hazard rate dominance, one gets: 1 − FB(˜ θ) > 1 − FR(˜ θ) ⇔
FB(˜ θ) <F R(˜ θ), which implies
∀θ <θ<˜ θ : fR(θ) >f B(θ)a n d∀θ <θ<˜ θ : FR(θ) >F B(θ). (10)
Step 2
Now, suppose there exists an intersection between FR(·)a n dFB(·)a tθ .P i c k
the smallest θ . Once again by the hazard rate dominance, we get: fB(θ ) <
fR(θ ). This, however, implies that
FB(θ  ) >F R(θ  ), (11)
for some θ   arbitrarily close but below θ .
If θ  is smaller or equal to ˜ θ from step one, we get a contradiction to (10). If θ 
is larger than ˜ θ,t h e nc o n t i n u i t yo fFB(·)a n dFR(·) together with equations (10)
and (11) assure the existence of a θ    ∈ (˜ θ,θ  ) such that FB(θ   )=FR(θ   ).
But this is a contradiction to the θ  being the smallest such value.
Overall, we cannot hold the supposition that there is an intersection between
FR(·)a n dFB(·). By equation (10), it must then be true that
∀ θ ∈

θ,θ

: FB(θ) <F R(θ). (12)
P r o o fo fam i l d e rv e r s i o no fR e s u l t3
Result 4. Given assumption (4) and FB(θ) ≤ FR(θ), blue agents generate
a larger expected surplus: EB [π (aB(θ),θ)] ≥ ER [π (aR(θ),θ)], where equality
holds if and only if the optimal assignments to blue and red agents are identical
on all open sets and
FB(θ)
FB(θU)−FB(θL) ≥
FR(θ)
FR(θU)−FR(θL) on any interval ]θU;θL[
where aR(θ) is strictly increasing.
Proof. Since the mechanism must be incentive compatible and the single cross-
ing property holds, the optimal ai must be a non decreasing function in θ (see
e.g. Fudenberg and Tirole (1991) Theorem 7.2). First, we want to show that
this implies monotone increasing proﬁts. Suppose, proﬁts would fall close to
θ : π (ai(θ),θ) <π(ai(θ ),θ  ) ∀θ ∈ ]θ ;θ  ]. Consider the incentive mechanism
where all types between θ  and θ   get the assignment ˜ ai = ai(θ ) and receive
the payment ˜ xi(θ)=−
 θ
 
θ
∂
∂θc(ai(t),t)dt + c(ai(θ ),θ  ), whereas assignments
and payments stay the same for all agents below θ  and agents larger θ   keep
7their old assignment and get −
 θ
 
θ
∂
∂θc(ai(t),t)dt + c(a(θ ),θ  ) − c(a(θ  ),θ   ) −
 θ
θ  
∂
∂θc(ai(t),t)dt+c(ai(θ),θ). This mechanism fulﬁlls participation and incen-
tive constraints. Moreover, the mechanism leads to larger or equal proﬁts for
all θ>θ  . In particular, the proﬁt generated by θ   is identical to the proﬁt gen-
erated by θ . Hence, the proﬁt under optimal assignments can’t be decreasing
and due to the ﬁrst order stochastic dominance, we get:
EB [π (aR(θ),θ)] ≥ ER [π (aR(θ),θ)]. (13)
If the optimal ai chosen for θ   is strictly larger than that for θ , the proﬁt for
θ   must be strictly larger as well. Given there is some interval ]θU;θL[w h e r e
aR is strictly monotone, then πR is strictly monotone on this set and if addi-
tionally blue agents have more probability mass to the right (
FB(θ)
FB(θU)−FB(θL) <
FR(θ)
FR(θU)−FR(θL)), the inequality is strict.
Since the incentive and participation constraint are independent from the dis-
tribution, giving blue agents the assignments of red agents is feasible (although
not necessarily optimal) and hence
EB [π (aB(θ),θ)] ≥ EB [π (aR(θ),θ)]. (14)
If there is an open set where assignments between blue and red agents diﬀer,
the strict inequality will hold. Putting (13) and (14) together, we obtain the
result.
8

Game Theory.

Hierarchical Decentralization of Incentive Contracts,”

Okonomische Theorie der Vertr¨ age. Mohr (Siebeck), T¨ ubingen.

The Statistical Theory of Racism and

The Virtue of Being Underestimated: A Note on Discriminatory Contracts in Hidden Information Models

http://www.wiwi.uni-bonn.de/bgsepapers/bonedp/bgse18_2001.pdf

The Virtue of Being Underestimated: A Note on Discriminatory Contracts in Hidden Information Models

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