RAND Journal of Economics Vol. 29, No. 2, Summer 1998 pp.

339-354

The value of ignorance

Anke S. Kessler*

This article provides a new perspective on the information structure of an agent in a standard model of adverse selection. Before contracting takes place, the agent has the opportunity to gather (private) information on a relevant parameter that affects final payoffs. I allow for the possibility that the agent remains uninformed with some probability. The agent's optimal choice of information structure is derived, and it is shown that in the case of two states of nature, the possibility of remaining ignorant has a positive strategic value for the agent. Since a poor information structure generates strategic benefits, there will be no equilibrium in which the agent is perfectly informed even if additional information is costless at the margin.

1. Introduction
* In recent economic theory, much theoretical as well as applied work has been done in the context of principal-agent relationships with adverse selection. Most of the models in the literature take the information structure of the agent as exogenously given. In particular, they presume that whereas the agent is perfectly informed about a critical parameter (i.e., his "type"), the principal is not. In many interesting applications, however, this assumption seems unreasonable: if the information does not concern an inherent characteristic of the agent himself but rather a state of nature that is to be discovered or successfully predicted, the agent may have to spend resources to acquire information, and more importantly, his information structure may not necessarily be perfect. To illustrate this idea, consider for example the case of government procurement. In the literature on this subject,' the firm chosen as a prime contractor is assumed to have full information about the future costs of realizing the desired project. In practice, however, the firm often has to incur research expenditures to obtain superior knowledge about the necessary technology or input costs. Furthermore, the attempt to acquire additional information may not always be fruitful, i.e., the firm may end up sharing the procurement agency's imperfect information on these parameters. Clearly, devoting more resources to this activity increases the likelihood of obtaining valuable information. The crucial point to recognize is that the firm can decide for itself whether it
* University of Bonn; kessler@wipol.uni-bonn.de. An earlier version of this article was presented at the 1995 conferences of the European Economic Association (Prague) and the Verein fur Socialpolitik (Linz). I wish to thank the conference participants, Georg N6ldeke, Christoph Ltlfesmann, Klaus Schmidt, Urs Schweizer, and Steinar Vagstad for helpful comments and discussions. Financial support by the Deutsche Forschungsgemeinschaft, SFB 303, at the University of Bonn is gratefully acknowledged. Remaining errors are my own. i See, e.g., Laffont and Tirole (1993) for an extensive treatment and the references therein.

Copyright (? 1998, RAND

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wants to gather this information and, if so, how much. In other words, the fact of being privately informed as well as the accuracy of this information may be choice variables in the firm's decision problem.2 To analyze some of the consequences of endogenizing the information structure in agency models of adverse selection, I focus on a simple procurement problem. A principal hires an agent to realize a project. Before contracting takes place, the agent can acquire information on the future cost of completing the project (equivalently, one could also formulate a regulation model in which the utility conducts research on its costs of investment or on market demand before the hearings). The underlying idea here is that a formal contract can be written only after the agent provides a "blueprint" of the project and that he can gather relevant information while developing the blueprint. If the agent has not obtained any information about project costs, he remains uninformed during the entire game and discovers the true costs only after the project is completed.3 A critical assumption of the model is that the agent can commit himself to a certain information structure before contracting takes place. The agent's commitment ability, together with the fact that he may remain uninformed at the project completion stage, has important consequences for his decision to gather information. Specifically, I shall show that ignorance may generate strategic benefits even though private information guarantees the agent a positive rent under the optimal contract. For the case of only two possible cost realizations, I demonstrate that the agent always strictly prefers to remain uninformed with some positive probability, although additional information is costless and although the principal can commit herself not to pay for any cost overruns (the agent faces a "hard" budget constraint). Expressed differently, an agent who does not acquire full information on project costs is, in equilibrium, better off than an agent who is perfectly informed: he may therefore have an incentive to build a reputation for making errors in his cost estimates. Conversely, the principal is shown to prefer agents who are (privately) informed with probability one and would be willing to subsidize the agent's cost of information acquisition. The intuition behind these results is that the possibility of facing an ignorant agent induces a shift in the probability distribution of project costs as perceived by the principal. Specifically, it reduces the likelihood of low-cost outcomes: from the principal's point of view, the agent effectively realizes low-cost projects less often even though the true distribution of cost realizations remains unchanged. This alters her optimal contract offer in a way that is beneficial to the agent. The findings illustrate that the difference between an exogenous information structure and one that can be derived endogenously may be substantial: in traditional agency problems with adverse selection, the agent is assumed to be perfectly informed even though he may actually be better off if he could commit to remain ignorant with some probability. There are relatively few contributions in the literature on endogenizing the agent's information structure in principal-agent relationships.4 Cremer and Khalil
2 A similar argument could be made in a regulatory context or in a situation where a wealth-constrained entrepreneur contracts with an investor to finance an investment project. 3 Alternatively, one could imagine that the size of the project must be (due to coordination or planning problems) determined before the uncertainty is resolved. The literature on the value of information under uncertainty has devoted much attention to this "irreversibility" of project development. See, e.g., Freixas and Laffont (1984) and the references therein. Another interpretation of the model is the procurement of a project of fixed size, where the unknown parameter concerns the costs of providing quality. Here, too, it is likely that total costs can only be observed after the project is completed. 4 For an analysis of information acquisition in the related context of auctions, see, e.g., Milgrom (1981), Lee (1982), and Matthews (1984), who analyze the incentives of bidders to obtain information on the value of the object before it is auctioned off.

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(1992) study a model in which the agent can accumulate information after the contract is offered but before he signs it (see also Craswell, 1988). Although the agent learns his future production costs in any case before production starts, precontractual information enables him to reject the contract in unfavorable states. The authors show that the optimal contract never induces precontractual observation and that the principal prefers agents whose cost of information acquisition is high. Moreover, the agent always benefits from additional information, which stands in sharp contrast to the result obtained in this article. Two subsequent articles (Cremer and Khalil, 1994 and Cremer, Khalil, and Rochet, forthcoming) investigate a similar setup with the modification that the agent may gather information before the contract is offered. Again, additional information is shown to improve the agent's welfare. The principal, however, does not necessarily suffer from lower information-acquisition costs. The crucial assumption in their setting is that the agent learns the relevant state of nature prior to production, irrespective of whether he has acquired information or not. As a consequence, the probability distribution as perceived by the principal remains unchanged, despite the fact that the agent may be ignorant ex ante. The present framework, in contrast, presumes that the state of nature is revealed only after the project has been completed and draws quite different conclusions. The present article is also related to a different line of research that investigates the possibility of ignorance involving strategic benefits for the principal. In a repeated principal-agent framework, Cremer (1995) and Dewatripont and Maskin (1995) show that the principal may deliberately refrain from information acquisition if the initial contract can be renegotiated: by remaining uninformed, the principal can in the renegotiation phase commit herself not to take actions that are undesirable from an ex ante point of view. In a similar spirit, Riordan (1990) demonstrates that ex post information on the agent's cost parameter can destroy his willingness to invest in cost reduction ex ante. Finally, Caillaud and Rey (1994) analyze the optimal information structure of producers with respect to the characteristics of their retailers. The authors show that ignorance creates a strategic advantage in the market game that may outweigh the associated agency costs. The remainder of the article is organized as follows. Section 2 introduces the model. I derive the optimal incentive contract for the principal, taking the information structure of the agent as given. Then I analyze the agent's optimal choice of information structure and demonstrate that the agent benefits from the possibility of ignorance. In Section 3 I briefly consider the extension of the model to more than two states of nature. Section 4 concludes and explores possible applications. All proofs are relegated to the Appendix.

2. The model
* Description of the game. Consider a simple procurement model in which a principal (P) hires an agent (A) to realize a project of size x E X C Ro.5 The value of this project to the principal is represented by a strictly increasing, strictly concave function V(x). The agent's costs C(O,x) of realizing the project depend both on the project size x and on the realization of a random parameter 0 E { 0, 0 } at the date of completion. Assume C, > 0, C,, > 0, C(0, 0) = 0 VO E {0, 0}, and C (0, x) > C(0, x) Vx > 0. Initially, both parties assess probabilities q and 1 - q to the low-cost and high-cost state, respectively. In contrast to the agency models analyzed in most of the literature,
5The analysis in this article is confined to the case where there is only one potential supplier of the project. This assumption is justified if a prime contractor is chosen before full-scale development (as is, for example, often the case in government procurement). As a result, prices cannot be competitively determined

and contracts are negotiated between the principal and a sole source.

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I will not assume that the agent is perfectly informed about the value of 0 when contracting takes place. 0 is to be interpreted as a state of the world that will affect project costs and must be discovered or successfully predicted. The model is designed to allow for the possibility that the agent remains ignorant and to endogenize his decision to acquire information on 0. Formally, the agent can at date 0 receive a private signal s E {0, 0, so} about the value of 0. Having observed s E {0, 0}, the agent knows that future project costs will be exactly C(s, x). The signal so, however, provides no information on 0 and leaves the agent ignorant.6 An ignorant agent shares the principal's imperfect knowledge of 0. The probability of receiving a "valuable" signal s E {0, 0(} is represented by the parameter rr e1 [0, 1]. Define the expected project costs of an uninformed agent as CO(x) qC(0, x) + (1 - q)C(0, x). To acquire information (receive signals), the agent can conduct research on the value of 0 before contracting takes place. The information technology available to the agent is formally represented by a continuous function y: [0, 1] -> R+, where y(ir) are the (monetary) research expenditures necessary to be informed with probability rr.It is natural to assume that if A wants to increase the likelihood of receiving a valuable signal, the amount of resources devoted to research activities must increase, i.e., 0 with strict inequality if iT> 0. oy'(,i) After the agent has decided on his research expenditures and observed his private signal, the principal proposes at date t = 1 a contract to the agent that specifies a project size x(s) and a transfer t(s) to the agent if his announcement is s. Given that the principal can commit herself not to renegotiate the contract, the revelation principle ensures that we can restrict the analysis to this direct-revelation mechanism. In the present framework, the announcement of s can also be interpreted as a (binding) cost estimate of the agent: if the principal wants to realize a project of size x, projected costs are C(s, x) if s E {0, 0(} and CO(x)if s = so. Both parties are risk neutral and their respective reservation utilities are normalized to zero. For a given project size x and a transfer payment t, the net benefit of the principal is up = V(x) - t and the payoff to the agent is UA = t - C(0, x). At t = 2, the project is completed, and at t = 3, transfers are made and payoffs realized. The time structure of the model is summarized below. t = 0: A decides on research expenditures -yand receives a private signal s. P observes the agent's choice of -ybut does not observe S.7 t = 1: P offers a contract {t(s), x(s)}. A accepts or rejects the contract. If the contract is rejected, the game ends and both parties obtain their reservation payoffs. t = 2: If A has accepted, he announces his signal s and realizes the project of size x(s) according to the terms of the contract. t = 3: P pays the transfer payment t(s) to A and payoffs are realized. The principal's problem. The principal's objective is to maximize her expected a revenue from the project, subject to the constraint that the agent accepts the contract and truthfully reports his signal in equilibrium. For notational simplicity, let (1',x) and
6 The setup is based on the model by Lewis and Sappington (1993), who have provided the first analysis of ignorance in agency problems. Their focus, however, is different: they are not interested in endogenizing the informational structure of the agent and concentrate instead on the consequences of ignorance for the shape of the optimal contract. 7 The implicit assumption here is that monetary expeditures on research are observable but cannot be contracted upon. In the model with two possible states of nature, the qualitative results are unaffected by the fact that the principal actually observes y (see the subsection below on the agent's problem).

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(t, x) denote the contract for an informed agent who claims to have observed signal s = 0 and s = 0, respectively, and let (to, xo) denote the contract for an agent who announces that he is uninformed. Assumption 1. (i) lim,-0 V'(x)
(ii) CX(O' x) >
=

oc,

lim
Vx

e0 E X

V' (x)

CX(O' x)

(iii)

CXX(6, x) :: CXX(O'x)

Vx E X.

The first part of Assumption 1 states that the principal values the project sufficiently so that she never wants the agent to realize a project of size 0 (i.e., no project).8 Part (ii) is the single-crossing property, which ensures that the agent's indifference curves in the (t, x)-space are well behaved. Part (iii) guarantees that the second-order conditions in the principal's maximization problem are satisfied. Any contract that induces truth telling must satisfy the following incentive constraints: f - C(O, t-C(0, ) t -C(O,X) xo) (1) (2) (3) (4) (5) (6)

)-to-C(O,

t - C(O, x) ' f t-C(0, totox)-to-C(0, Co(xO)' t

-

C(O, x) xo) Co(x)

Co(xO)' t -C(c).

Constraints (1) to (4) ensure that an informed agent who has observed a valuable signal s = 0 will gain neither by announcing s = 0, 0 $ 0, nor by claiming that he is ignorant. Constraints (5) and (6) state that an ignorant agent will never claim to be informed. Note that (2) and (6), together with the single-crossing property, imply the monotonicity condition (M):9
X: x.

Since the principal always wants the agent to realize a project of positive size, she must guarantee that the agent will accept the contract for all possible signals. Hence, the following participation constraints must be satisfied: f - C(O, Y)-0 t - C(0, x) ?0
to-

(7) (8)
(9)

CO(xO) ? 0.

Recall that any costs of information acquisition are sunk at this stage and do not enter the participation constraints. A contract is called feasible if it satisfies the incentive constraints (1)-(6) and the participation constraints (7)-(9). Note that the incentive-compatibility constraints (4) and (6), together with the participation constraint (7), ensure that (8) and (9) always hold and can therefore be dropped. In what follows, we can also ignore the constraints (1), (2), and (5). It is easy
8 This

assumption is not necessary but it simplifies the exposition considerably.

9 Constraints (4) and (5) also imply a monotonicity condition, x ? xO. Under the optimal contract,

however, this condition is never binding and is therefore omitted. The reason for this is that the principal
will optimally set x to its efficient level, whereas x0 will be distorted downward.

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to verify that the solution to the principal's problem will meet them. The remaining constraints are the truth-telling constraints for the low-cost agent and the ignorant agent, the monotonicity condition, and the participation constraint for the high-cost agent. Having observed the firm's research expenditures -y,the principal knows the probability ir with which the agent is informed.'0 Her optimization problem at date 1 is then given by
max
(7,T),(t,X),(t0,x0)

Tr[q(V(x)

t) + (1 -

q)(V(Y)

f)]

+ (1 -

T)[V(xo)-to]

subject to
t-C(0, t X) to-C(0,
-

xo)

(4) (3)

C(O, x) 2 t

C(O, Y) Co(x)

tof -

C0(xo) 2
C(O, Y) 20

t-

(6)
(7)

X'

Y.

(M)

Notice that as long as there is a positive probability that the agent is not informed about the value of 0, we can also drop the constraint (3): if (6), (4), and (M) hold, then (3) holds. The constraints (4), (6), and (7) will, however, be binding in the optimal solution (if one of them were slack, the principal could decrease the appropriate transfer while keeping the other constraints satisfied). We can now substitute for the transfers and write the Lagrangian of the problem,
L = ir{q[V(x)
X [V()
-

C(0,x)
C(OY)]}

Co(xo) + C(0, xo) - C(0, Y) + Co(x)] + (1 - q)

+ (1
-

Tr){V(xo)

Co(Xo)

[C(0,)

CO()]}

g(

-Xo)

where ,

0 is the multiplier for the monotonicity constraint (M). Define

?>(x) = C(0, x) C(0, x) > 0

as the difference in total costs of a project of size x between the high-cost state and the low-cost state and note that, by Assumption 1, ?'(x) > 0 and ?"(x) 2 0. Using
CO(x) = qC(0, x) + (1 -q)C(0,
V'(x) = C'(0, x) + q(1 -

x), the first-order conditions

are
(10)

V'(xo)

C'(xo)

q)

1 -X

'(Xo)

1 -'T

(11)

V'(x)

= C (0, Y) + q

+ rrq
rr(1 -

q)

drr)

(1 P(12 - q)

(12)

The possibility that the agent may be ignorant is technically equivalent to the presence
10To be more precise, recall that the function -y(17r)is, by assumption, strictly increasing in ir. The principal is therefore able to infer from the observation of y the exact value of Ar.If, however, the principal could not observe vy,X could also be interpreted as her belief on the probability that the agent is informed.

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of a third type of agent whose costs are the expected costs CO.As a consequence, the solution is similar to the solution of a standard problem. The level of x is efficient and both xOand x are distorted downward. It remains to analyze when the multiplier will be zero and the monotonicity constraint will be nonbinding. Lemma 1. There exists a hr E (0, 1) such that
(i) for rr > (ii) for rr ? r, ,> 0: the monotonicity
r, /, = 0: the monotonicity

constraint binds, constraint does not bind.

Lemma 1 states that if the agent is informed with a relatively high probability rr, it will not be optimal for the principal to distinguish strictly between an agent who is uninformed and an agent who has received a signal s = 0 in the sense that xOis different from x. In other words, if it is not very likely that the agent is uninformed, any optimal
contract will set xO = x. If ir is below the critical level does not bind, and we have xO > x. hr,the monotonicity constraint

The intuition for Lemma 1 is simple: if the principal knows that the probability of meeting an uninformed agent is very small, she would ideally like to set xOas small as possible in order to reduce the rent of the agent in the low-cost state. xOcannot be made arbitrarily small, however, because an uninformed agent wouldthen have an incentive to claim that he is informed and has observed the signal s = 0. Technically, this result follows from the fact that the distribution is badly behaved for large 'I: it does not satisfy the monotone hazard rate property, so the optimal contract pools the uninformed and the high-cost type. Consider first the case iT Thr. From Lemma 1, we know that the principal will
set xO = x. The first-order conditions V'(x)
V' (x)

now reduce to (13)

+
-

= C'(O, X)
= V'(xO) = C' (0, x)

(1

+ rr1

q) q)()

(14)

The appropriate transfers are

t
=

C(0, x) + +(x)

(15)

and
t= o=

C(O, x).

(16)

Setting rr = 1 yields the standard solution in this adverse-selection framework, where the agent is perfectly informed about 0. In particular, note that the expected rent of an agent who is informed with probability 1 is, before observing his signal, given by

4VP(xP) = q[t
=

C(O,
>

xP)] 0,

+ (1 -q)[t

C(O,

TP)]

(17)

qq(TP)

where x-Pis the value of x that solves (14) at ir = 1. Now suppose rr < 7. The corresponding optimal project sizes for the different types of firms are then determined by equations (10)-(12), where /, is set equal to zero.

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We obtain
V'(x)
V'(xo)

= C'(0, x)
=

(18)
-

C'(xo)

+ q (1

q)

IT

4V(xo)
Ir)P)

(19)

V'(Y)

Y) +

rq +

'Trq + (1-

01(y)

(20)

for the optimal levels of x and

t = C(0, x) + (1
-

q)4o(xo) + q4(Y)

(21) (22) (23)

to = C0(x0) + q4(Y)
=

C(O, Y)

for the respective transfer payments. As usual in this type of agency problem, the transfer for an informed agent who knows that costs will be low exceeds total project costs in both cases: the agent earns a positive rent. Notice, however, that this is (in expected terms) also true for an uninformed agent: although the information with respect to estimated project costs is symmetric, the principal cannot separate an informed agent from an uninformed agent at the contracting stage. As a consequence, even an uninformed agent will earn a positive rent under the optimal contract. Having solved the principal'sproblem for a given probabilitythat the agent is informed, we can go back to stage 0 of the game and ask how much the agent is willing to spend to acquire information on 0, taking into account the principal's contract offer at stage 1. The agent's problem. At date 0, the agent must decide how much to invest in a information acquisition. Of particular interest in this framework is whether we can identify circumstances in which he chooses to be informed with probability 1, i.e., whether we can endogenously generate the information structure that has traditionally been assumed in the agency literature. For the moment, I will neglect the costs of information acquisition and instead focus on how the agent's expected rent, denoted varies with the probability IT of being informed. Recall from Lemma 1 that by FD(-), the optimal contract is degenerate in that it specifies only two possible pairs for IT: hr, of different transfers and project sizes: one pair for the agent who has observed the signal s = 0, and one pair for both an uninformed agent and an agent who has observed the signal s = 0. In the case of two possible cost realizations, this degenerateness has a special implication that is presented in the following lemma, which will prove helpful in explaining the intuition behind the results subsequently derived. Lemma 2. Take any feasible contract C {(-, x); (t, x); (to, xo)} with x = x0 and i = to that satisfies the incentive-compatibility constraint for the low-cost agent with equality. Then, for a fixed contract C offered at stage 1, the expected rent of the agent at stage 0 from this contract is independent of his probability Ir of being informed. Lemma 2 states that there is no direct negative effect from being uninformed: holding the offer of the principal fixed at a contract C, a change in Ir will have no effect on the agent's expected rent from this contract. As long as P continues to offer such a contract. A will be indifferent between being informed with probability 1 and being informed with any probability IT < 1, provided that research costs are not a

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matter of concern. The result is driven by the facts that the contract C does not discriminate between an uninformed agent and an agent who has observed s = 0 and that the incentive-compatibility constraint for an agent who has observed the low-cost state is binding. Since x = x0 and I = to, an uninformed agent will not be worse off if he discovers ex post that his costs are 0. Conversely, an uninformed agent whose true costs have turned out to be 0 will also be (due to the binding incentive-compatibility constraint) ex post indifferent between a project of size x for a transfer I and a project of size x for a transfer t. As a consequence, the agent does not suffer from his ignorance. We can now state Proposition 1. There exists a value X < A, such that the agent's expected rent (F(-) if he is informed with probability X E [t, 1) strictly exceeds his expected rent if he is perfectly informed, i.e., if X = 1. Moreover, 'F(-) is strictly decreasing in the probability 7. IX of being informed for all values X ' The first part of the proposition asserts that for a range of parameter values IT, the agent is better off remaining uninformed with a probability XT < 1 than being perfectly informed. This is at first puzzling. One would intuitively think that the agent's strategic advantage is highest when his probability X of being informed is equal to one. In this model, however, the possibility of remaining ignorant has a positive strategic value for the agent. The second part of the proposition derives a comparative static result for this value: it is decreasing in the probability g7r for all values 17rE (#, 1). To obtain the intuition for this rather unexpected result, recall that as long as IT is not too small, the principal does not discriminate between an agent who has received a signal s = 0 and an agent who is ignorant. From the principal's point of view, the likelihood that a project of size x is realized is therefore higher if A is uninformed with a positive probability as compared to the case where A has full information on 0. For the principal, the possibility of ignorance shifts probability mass from the low-cost to the high-cost state: although the true distribution over 0 has not changed, the agent has in fact committed himself to announce 0 more often. Accordingly, the principal raises the size of the project in this state: it is now more likely that an inefficiently small project in the high-cost state is realized. The agent gains from a rise in xi, since the information rent he receives is higher the larger is x. Notice, however, the crucial role that Lemma 2 plays in this argument. From Lemma 2, we know that for values of IT E [ 1), ignorance has no direct effect on the agent's expected payoff, and the only remaining effect is the positive effect on the optimal contract offer at stage 1.11 Since (L(-) is continuous in I, it must still be above (DP even if IT drops below X and Lemma 2 no longer applies (the optimal contract discriminates between an ignorant agent and an agent who knows that costs will be high). Hence, there must exist some X < X above which (L(-) exceeds the expected rent under perfect information, (DP. The principal, in contrast, is strictly worse off if the agent is uninformed with a positive probability in the range [*, 1). To see this, note that the optimal contract if IT EI-[f, 1) is also a feasible contract if X = 1. In addition, the probability distribution is less favorable (in the sense that the probability that a project of size x is realized less often) if I is strictly smaller than one. Formally, E{VIIT = 1 } = q(V(xP)
> q(V(x) > Iq(V(x) =E{VI
The next section provides an example iT E
-

tP) + (1 t) + (1 -t)

q)(V(-P)

tP)

q)(S(xT) - t) Iq)(V(x)
-t)

+ (1 1) },

[T

showing

that in the case of more than two states of nature,

the results are not as clear-cut as in the analysis presented here.

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where the first inequality represents the revealed-preference argument (because the optimal contract is unique, this inequality must be strict) and the second inequality simply arises from the fact that the principal's payoff is higher if costs are low than if
costs are high.12

To summarize, for a range of possible values of IT, the agent's payoff is strictly higher than under complete information and the principal's payoff is strictly lower. So far, we have treated iT as a parameter and ignored the agent's costs of information acquisition. Clearly, taking those costs into account in the precontractual phase only makes matters worse. If the agent is better off remaining uninformed with a positive probability, he will not be willing to spend additional resources to become fully informed. Since his expected rent in the continuation equilibrium following his decision to gather information, (D(-), is decreasing in iT for values above A, it can never be optimal for the agent to increase the quality of his signal beyond A. Furthermore, the assumptions made on the function y(-) guarantee that it also cannot be optimal to remain uninformed with probability 1, i.e., to set y = 0. After all, becoming informed has a strategic value for the agent, namely his information rent: if the agent remains completely uninformed about the future value of 0, the principal can offer a contact with to = Cj(xo), leaving no rents to the agent. The following theorem summarizes the results. It is a straightforward implication of Proposition 1 and the preceding discussion. Theorem. In equilibrium, the agent chooses to be privately informed about the state of nature with a probability i* that is strictly positive and bounded from above by the threshold value X < 1. This threshold value is independent of his costs of information acquisition. More precisely, each subgame-perfect equilibrium of the game is characterized by a level of research expenditures iy* and a corresponding probability of being
informed I*(Qy*) that satisfy y and (i) 0 < it* y(1) T < 1, (ii) 0 < T* for any strictly positive Hy'(e).

The theorem states that there does not exist an equilibrium of this game in which the agent is perfectly informed about the value of 0 even if additional information becomes costless at the margin. Any corner solutions (in particular, the case of IT = 1) are ruled out. Two remarks are in order: First, there may be multiple equilibria in this game. Since I(D) is not necessarily concave in IT, one cannot guarantee that there will be a unique value of -ythat maximizes the agent's expected net payoff without imposing additional structure. Second, suppose that increasing the probability of receiving a valuable signal at stage 0 is completely costless for some range of IT, i.e., y'(IT) = 0 over some interval [IT1, IT2]. In this case, the principal cannot infer from the observation of -y the exact value of A: a rational principal will then form beliefs X E [IT1, IT2] on the probability that she faces an informed agent. If X ' A, then the principal will, based on these beliefs, offer a contract defined by equations (13)-(16). From Lemma 2, we know that given such a contract the agent's expected rent is independent of IT and his net expected payoff only depends on research expenditures y (which are constant over the considered range). Hence, if [IT1, IT2] C [I, 1], then each y* such that the corresponding probability iT* is in the interval [IT1, IT2] and the principal's beliefs X = iT* (with the corresponding optimal contract offer) constitute a perfect Bayesian equilibrium. Note, too, that a similar argument could be applied when research expenditures are not readily observable by the principal. This result is special to the case of
12 Strictly speaking, this too is a revealed-preference argument: if the principal did not gain if the agent announces s = 0 as compared to s = 0, a contract with x VFB and t = C(6. XFB) would have been optimal.

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two possible cost realizations where, for high values of IT, the principal's optimal contract offers are such that the agent does not suffer from being ignorant.13

3. Extension: more than two states of nature

* This section briefly considers the case of more than two possible cost realizations and provides a more general discussion of the economic forces at work. As we shall see, extending the model allows us to identify and characterize two different effects of ignorance on the agent's expected payoff. The first is a strategic effect: by choosing his information structure at stage 0, the agent manipulates the way the principal designs the optimal contract at the subsequent stage. The second effect is the direct effect of ignorance: remaining uninformed ceteris paribus restricts the agent's ability to act optimally given the prevailing state of nature. For shortness of exposition, I confine myself to an example demonstrating that the combined effect is in general ambiguous. The analysis also helps to clarify what special features of the two-type case are responsible for the results in the previous section. The conclusions for the case of more than two states of nature can be stated as follows. First, the principal's best response to the agent's ignorance is not necessarily beneficial for the agent, i.e., in contrast to the previous section, the strategic effect of ignorance may not be positive. To see this, note that a positive probability of ignorance will (as in the case of two possible cost realizations) induce pooling for a range of outcomes around (to, x0). On the one hand, this will tend to increase the rent of all agents with relatively low-cost signals. On the other hand, the concentration of probability mass around C0 shifts probability away from the endpoints of the distribution so that high realizations of 0 become less likely. Unless the outcomes for these highcost realizations are included in the pooling range, the principal will distort the project size in these states further downward, which has a negative impact on the agent's expected rent. Second, the direct effect of ignorance is negative if at least one type of informed agent strictly prefers truth telling to claiming to be uninformed (which will typically be the case for more than two cost realizations). Suppose that the agent who knows his costs to be C(O,x) strictly prefers to realize a project of size x(O) in exchange for a transfer t(O) rather than a project of size x0 for a transfer to. As a consequence, any uninformed agent who ex post discovers his cost to be C(0, x) (which happens with positive probability) is worse off as compared to a situation where he has ex ante information about 0. The following example illustrates these findings. Example. Suppose C(0, x) = Oxand 0 E {1, 2, 3, 4}. Let qi = Prob[O = i]i=1..4 = 1/4 and V(x) = 9x - /2x2. Expected costs are C0(x) = 5/2x. Let (xi, ti) and (x0, to) denote the contracts for an agent who claims to have observed cost 0 = i and an ignorant agent, respectively. Again, we can argue that if the probability iT of being informed is sufficiently high,14 the monotonicity constraint between x0 and X3 is binding. In this case, the optimal project sizes and transfer payments can be calculated to be
13 More generally, however, individuals will always (at least weakly) prefer to be informed in the absence of any strategic considerations: more information enables them to act optimally given the prevailing state of nature without limiting their choice set. It follows that any potential positive effect of ignorance must necessarily be a strategic effect that can only be taken advantage of if it is possible to commit to a certain information structure, e.g., if research expenditures are observable.

14

In this example, 7r

.87.

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4

xl = 8
X2

tl =
t2 = 2X2

xi
+
X3 + X4

= 6
= X3
=

XO

1 --

IT

o= 1
-

t3

3X3

X4

1T

4=

-4

Tt4

4x4.

IT I

The expected rent of an agent who is informed with probability en by

(7r = -'7T4X2 + X3(7T) + X4(

is accordingly giv-

IT[X + X4(7I)] + + 41TX3(7T)

rIT[x4(I7)]

(1

)[lX3(T)

X4(T)].

Taking derivatives with respect to ITyields

dt?(.)
aIT
=

1 =-(X2

- X(I))

+--+

1 X3

2 aiT

I 1IT1

\aX4

4 IaIT

As indicated above, we can decompose the change in the agent's expected rent caused by a small decrease in the probability I of being informed into two effects. The direct effect is negative and given by-?/4(X2 - x4(T)). This effect arises because under the optimal contract, both an agent who observed 0 = 1 and an agent who observed 0 = 4 strictly prefer to tell the truth as compared to claiming to be ignorant (the respective incentive-compatibility constraints are slack). It follows that the difference in rents of an ignorant agent whose costs ex post turn out to be 0 = 1 (respectively 0 = 4) and an agent who has ex ante observed 0 is negative and given by -(X2 -(X3 (to Xo) (tl X3) (respectively, (to - 4xo) - (t4 4x4) xl) The expected sum of the losses in both situations (each of which occurs with a prob< 0. ability of 1/4) is -/4(X2 X4(T)) The strategic effect is characterized by the principal's best response to a drop in A: by increasing his probability of being ignorant, the agent shifts probability mass to the allocation (X3, t3). The principal's optimal reaction is to increase X3 and to decrease x4, leaving xl and x2 unchanged. The rise in X3 has, as before, a positive impact on the information rents of the informed types i = 1, 2 and the ignorant type. The output distortion of X4, however, becomes more severe, which at the same time decreases the rent for all types i # 4. Both effects must be taken into account (weighted with their respective probabilities) when calculating the strategic effect. It is immediate that the sign of this effect is ambiguous: it depends on the utility functions of both principal and agent and on the probability distribution over types.15 In this example, the strategic effect can be shown to be positive for values of ITclose to one, but the direct negative
= = X4)). 15 Lewis and Sappington (1993), for instance, consider a continuum of outcomes with a uniform distribution over types. In their example, the output distortions induced by the possibility of ignorance are so severe that (translated to the present framework) no project would be realized in about 50% of possible cost realizations.

KESSLER

351

effect is strong enough to offset any positive strategic effect. To see this, evaluate the derivative of the expected rent at XT = 1 to obtain
as(D
a1T

1
41

1 2

/ 4

1\

Here, the two effects just offset each other for marginal changes in the composite effect will be negative for all iT < 1.

IT

at

IT

= 1, and

4. Summaryand conclusions
* This article has investigated the decision of an agent to acquire ex ante information on the value of a relevant parameter in the context of a standard agency model. Despite the fact that the agent's private information ensures that he earns a positive rent in equilibrium, he may voluntarily choose to remain ignorant with a positive probability. The basic intuition behind this rather counterintuitive result is straightforward. The possibility of ignorance introduces an additional dimension of informational asymmetry: even though the information with respect to the prevailing state of nature is symmetric if the agent has not received valuable information, he is still privately informed with respect to his informational status (the quality of his signal), which alters the terms of the optimal contract in a way that is beneficial to him. In the case of two states of nature, this effect is always present and the agent strictly prefers to remain uninformed at the contracting stage even if additional information is costless. In this sense, the assumption on the agent's information structure in standard agency models is not robust: the agent may be willing to spend a positive amount to ensure that he is not perfectly informed. Unfortunately, the discussion in Section 3 also shows that in the present framework, no general conclusions on the strategic value of information can be obtained, which makes this issue an exciting topic of future research. Finally, let me point to two possible applications that fit into the model presented here. As already mentioned, if the announcement of the signal is interpreted as a binding cost estimate, the model endogenously generates cost overruns in equilibrium. There will also be cost underruns, of course. However, it can be shown that if high costs are more likely, the probability that the agent is uninformed in equilibrium increases: provided that the cost estimate of an agent is incorrect, a cost overrun is therefore more likely than a cost underrun. Moreover, the marginal benefit of ignorance in this model increases with the size of the project, x. The model could therefore provide a rationale for the frequently observed cost overruns in government procurement projects, most of which are of considerable size and have an inherent uncertainty attached to them. Naturally, any "soft" budget constraint on the side of the government will decrease incentives to acquire ex ante information even further. Second, the fact that the principal suffers if the agent is not fully informed may prompt her to subsidize the agent's costs of information acquisition. Consider, for example, a firm that plans to introduce a new product, say a new computer generation, to the market. Next, suppose that the firm faces two possible consumer groups: uninformed consumers who (due to their lack of computer experience) are uncertain of their valuation of the product, and informed consumers, a fraction of whom already own the preceding computer generation and therefore have a relatively low willingness to pay. The rest of the informed group are those who have long been deferring their purchase in expectation of increasing capacity and speed and have a high willingness to pay. Assume that the firm can use nonlinear tariffs to price discriminate among groups but cannot directly observe a customer's valuation. In light of the present model,

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the following conclusion would emerge: If the fraction of uninformed potential customers is not too large, the firm has an incentive to release information before final market introduction (e.g., through advertising) to reduce the costs of information acquisition of the uninformed. This is due to the fact that the uninformed buyers (who play the role of the uninformed agent) exert a positive externality on the informed buyers-the exact opposite of some results in the literature on quality and consumer search. Appendix
* The proofs of Lemmas 1 and 2, Proposition 1, and the theorem follow. constraint is ignored. The firstProof of Lemma 1. Take first the relaxed program where the monotonicity order conditions are
7T

V'(xo) - C6(xo) = q(l - q)

'(x0) 1i
-

(Al)

V'(x-)

- 00,

_x) =q

I(1
7r(I

7r) q)

(A2)

Note that the right-hand side of equation (Al) is strictly increasing equation (A2) is strictly decreasing in 7r. We can now apply a simple as 7r -* 0, the right-hand side of equation (A2) tends toward infinity, hand side of equation (Al), on the other hand, tends to zero, which efficient level xFB , defined by
VW(XgB) C'(xOB) = 0,

in 7r, whereas the right-hand side of intermediate-value argument: Clearly, which implies that x -* 0. The rightimplies that x0 approaches the ex ante

with xFB > xFB > 0. Hence, for 7r -* 0, x0 > x, and the monotonicity constraint is satisfied. Now consider 7r -* 1. From (Al), x0 - 0, since the right-hand side of (Al) - so. The right-hand side of (A2), however, "P> 0. It follows that x0 < x, which contradicts (M). By the monotonicity of the remains positive, and x relevant functions, there must exist a value *- such that for all 7r ' *, x0 2 x in the unconstrained problem, which implies , = 0 in the constrained problem. It is straightforward to show that this value is implicitly defined by (1 - *)/*-2 = (1 - q)2. For values 7r > *-, x0 < x in the relaxed program and the monotonicity constraint will be binding, i.e., 0. Q.E.D. ,L> Proof of Lemma 2. To prove Lemma 2, we can simply compute the agent's expected rent from a contract C contingent on the probability 7r of receiving a valuable signal. Since we require the contract to be feasible, it is individually rational and induces truth telling for all possible signals observed. The agent's expected rent is thus given by c1(7r, *) =
=

r[q(t - C(O, x)) + (1 - q)(t r[q(t - C(O, x)) + (1 - q)(7 -

C(0, C(6,

x))] ? (1 x))]

7)(to-

CO(xO))

+ (1 - 7r)(7-Co()),
-

after setting to = 7 and x0 = T. Rewriting yields

7 - CO(T) as q(7 - C(O, T)) + (1 -q)(7

C(6, x-)) and rearranging

cID(Tr,*)= 7rq(t - C(O, x)) + (1 -

7r)q(7 - C(O, T)) + (1 -q)(7

C(6, T)). constraint for the

Notice that the last term does not depend on 7r. By assumption, - C(O, x). Hence, low-cost agent binds: t - C(O, x) = c1(Tr, *) which is independent

the incentive-compatibility

q(t - C(O, x)) + (1 - q)(7 - C(0, T)), Q.E.D. rent is strictly higher

of 7r for given transfers and project sizes.

Proof of Proposition 1. I first show that for all values 7r E [*r, 1), the agent's expected than under full information. If the agent is perfectly informed, his expected rent is given by equation (17):

KESSLER ,P=q[C(6,
= qo(XP)

353

TP)-C(O,
>

Tn)]

0.

If 7T 2 r, Lemma 1 implies that the principal will offer a contract of the form {Qt, x), (7, x), (to, x0) }, with 7 = to and x = x0. The size of the project and the transfer payments under the optimal contract are given by Note that the incentive constraint of the low-cost agent binds, and Lemma 2 therefore equations (13)-(16). applies. From the proof of Lemma 2, the expected rent of the agent is given by
d1(.j17- E

Lfr,1))

q(t - C(O, x)) + (1 - q)(t - C(O, x)),

q[C(W, x) -C(O,

x)]

= q,0(7), after substituting the transfers t and 7. By the monotonicity

(f 1T E [.1)) >

of 4)(.), we have
x > 3F.

(DP (--

From the first-order conditions,

V (x)

C (0,

0)(1

ir)

IT(1 _

q)4(' (x)

and

V'(TP)

C'(6, T7)

1 -q

+(

) I

Note that the coefficient of 4)'(.) is larger for 7r = 1 than for 7r < 1. Since V'(-) - C'(.) is strictly decreasing in x and 4)'(.) is strictly increasing in x, it follows that x > TP and, hence, (1(7r E [*r, 1)) > (D)P. Again, we can apply an intermediate-value argument: We know that for 7r = 0, the agent's expected rent will be zero, i.e., c1(7r = 0) = 0. On the other hand, cI(*r) > (DP. Since c1(.) is continuous in 7r for all 7r E [0, 1], there must exist at least one #t < * such that cI)(it) = (DP. If there are several such values of 7r that satisfy this equality, pick the largest. It follows immediately that for all values 7r > #t, we have (I)(7r) > (D)P, which proves the first part of the proposition. Totally differentiating the first-order condition for x yields dc

dir
Hence,

[(I - 7r)+ 7r(

-q)]2

- CI4(p" 7rq (Pt V/ (1 -

7rq)

< 0.

as-l
a7
7re(r

q4)'(T)-dir < 0, dqr

which proves the second part of the proposition.

Q.E.D.

Proof of the Theorem. Let (y*, C*) be an equilibrium level of research expenditures and an equilibrium contract offer. Under subgame perfection, C* must be a best response to 7r*(y*). I first show that y* = 0 cannot be an equilibrium. Suppose, to the contrary, y* = 0. For 7r* = 0, the principal will optimally offer a contract of the form to = C0(xFB) and x0 = xFB (where xFB is defined as in the proof of Lemma 1), which extracts the entire rent of the agent. But since -y'(0) = 0 and c1(7r > 0) > 0, it would be optimal for the contradiction. It remains to show that y* cannot exceed y(*). agent to increase 7r slightly above zero-a Suppose y* > -y(*-) and consider a small decrease in y*. As long as -y'(7r) > 0, a marginal decrease in y will result in a marginal decrease in 7r, which in turn prompts the principal to offer a contract that guarantees a higher expected rent for the agent, by Proposition 1. Thus, the agent not only saves resources but also increases his expected rent: his net payoff unambiguously rises, which contradicts the assumption that y* is an equilibrium strategy. Hence, in a subgame-perfect equilibrium, we must have 0 < y* ? y(fr) and 0 < 7r* ' 7. Q.E.D.

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