Monetary Allocation Mechanism under Asymmetric Information and Limited Communication

Abstract

We consider the constitutional problem of choosing a social allocation mechanism of an endowment economy where individual endowments and preferences are subject to idiosyncratic shocks. Under idealistic environments, where individuals are honest or information and communication are free, the economy can implement the idealistic allocation mechanism which guarantees a Pareto optimal allocation or the first-best solution. Under asymmetric information (but with free communication), however, the economy should compromise with an suboptimal allocation mechanism, the second-best solution, due to the moral hazard and the adverse selection. This familiar conclusion of the incentive theory reverts when communication is not free. Then the economy should be satisfied with the third-best solution, where the pricing functions are linear again but money, serving as medium of communication, becomes essential.