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HIDDEN-INFORMATION AGENCY
By Bernard Caillaud,
8
Benjamin E. Hermalin
Introduction
Our purpose is to consider the problem of hidden information; that

is, a game between two economic actors, one of whom possesses
mutually relevant information that the other does not. This is a common
situation: The classic example being the “game” between a monopolist,
who doesn’t know the consumer’s willingness to pay, and the consumer,

who obviously does. Within the realm of contract theory, relevant
situations include a seller who is better informed than a buyer about the
cost of producing a specific good; an employee who alone knows the

difficulty of completing a task for his employer; a divisional manager
who can conceal information about his division’s investment
opportunities from headquarters; and a leader with better information

than her followers about the value of pursuing a given course of action.
In each of these situations, having private information gives the player
possessing it a potential strategic advantage in his dealings with the

other player. For example, consider a seller who has better information
about his costs than his buyer. By behaving as if he had high costs, the
seller can seek to induce the buyer to pay him more than she would if
she knew he had low costs. That is, he has an incentive to use his

superior knowledge to capture an “information rent.” Of course, the
buyer is information rent aware of this possibility; so, if she has the right
to propose the contract between them, she will propose a contract that

works to reduce this information rent. Indeed, how the contract
proposer—the principal—designs contracts to mitigate the informational
disadvantage she faces will be a major focus of this reading.
The Basics of Contractual Screening

Let us begin by broadly describing the situation in which we are
interested. We shall fill in the blanks as we proceed through this reading.
• Two players are involved in a strategic relationship; that is, each

player’s well being depends on the play of the other player.
• One player is better informed (or will become better informed)
than the other; that is, he has private information about some state of

8
Caillaud B. Hidden-Information Agency / Bernard Caillaud, Benjamin Hermalin. – The
Basics of Contractual Screening. – 2000. – P. 35-42.