It is self evident that people often hold different opinions about how the future will unfold. Standard models assume that these differences are a result of informational asymmetries. However, they could also be purely differences in prior belief resulting from inherent biases such as over-optimism. While differences in prior beliefs open up opportunities to make speculative gains, these gains may be difficult to realize when individuals cannot observe each other's beliefs. A natural question that arises is whether institutions or mechanisms can be design to overcome this informational asymmetry and help parties realize as much speculative gains as possible. The goal of this study is to take first step towards answering this question.
This study connects between two recent lines of research, one that studies the design of mechanisms that exploit behavioral biases of agents, and another that incorporates heterogeneity of beliefs into economic modeling. The main contribution is the development of a framework that allows for standard tools from the mechanism-design literature (which have been developed to deal with incomplete information regarding diversity in tastes) to be applied to contracting problems with incomplete information regarding diversity in prior beliefs.
This research focuses on two questions that are usually asked in the standard mechanism-design literature. The first question is, how can parties, who each may have some bargaining power, maximize the total speculative gains that they can make? The researchers apply a mechanism design approach to this question, in the context of a pair of models: a principal-agent model in which the two parties bet on the agent's future action, and a market model in which traders bet on the future price. They characterize interim-efficient bets in these environments, and their implementability as a function of fundamentals. In general, implementability of interim-efficient bets diminishes as the costs of manipulating the bet's outcome become more uneven across states or agents.
The second question is, how can a monopolist facing agents with diverse, but privately observed beliefs, maximize his speculative gains? The researchers argue that menus of contingent contracts that arise in principal-agent relationships can be interpreted as a consequence of the principal's attempt to screen the agent's prior belief. They present a model of bilateral contracting that captures these ideas, characterize the optimal menu and apply it to a number of economic settings.
Broader Impact: The methodology developed in this study has the potential to provide important policy implications in areas that concern scholars and practitioners outside the field of economics. In particular, the study is expected to provide important insights into the regulation of markets such as gambling, narcotics, credit, elderly care and health insurance, where providers may exploit the naivete of consumers who are overly optimistic or overly pessimistic with regards to their future consumption. The study is also expect to make a contribution in finance by providing a benchmark for the design of futures and derivatives in imperfectly competitive markets.
