Participation Constraints in Adverse Selection Models

This paper characterizes the optimal contract offered by an uninformed principal to an informed agent when the latter's reservation utility depends on his type. The informational rent is nonmonotonic so that interior types may have a vanishing rent or be excluded from trade. The paper identifies conditions for the optimal contract to be separating, to be nonstochastic, and to induce full participation. It also discusses the nature of the solution when bunching occurs. The results are applied to nonlinear pricing under price cap regulation and bypass competition and to competition in nonlinear pricing. Journal of Economic Literature Classification Numbers: D82, D42, D23, D78, L51, L15. 2000 Academic Press