Economics Game Theory Questions
Screening in contract theory refers to the process by which one party, typically the principal, gathers information about the characteristics or abilities of another party, typically the agent, in order to design an optimal contract. The principal uses screening to overcome the problem of asymmetric information, where the agent has more information about their own abilities or characteristics than the principal does.
In screening, the principal creates different contract options or mechanisms that induce the agent to reveal their private information. This allows the principal to make more informed decisions and design contracts that align the agent's incentives with their own objectives.
There are two main types of screening: adverse selection and moral hazard. Adverse selection occurs when the principal cannot distinguish between different types of agents before entering into a contract. In this case, the principal designs contracts that induce agents to self-select into different contract options based on their private information. For example, an insurance company may offer different insurance policies with varying premiums and coverage levels to attract different types of customers.
Moral hazard, on the other hand, occurs when the agent's actions are not perfectly observable by the principal after the contract is signed. In this case, the principal designs contracts that provide incentives for the agent to reveal their true effort level or actions. For instance, a performance-based compensation scheme may be used to motivate employees to exert more effort and increase productivity.
Overall, screening in contract theory is a crucial tool for principals to mitigate the adverse effects of asymmetric information and design contracts that align the interests of both parties involved.