Contracting between Two Parties with Private Information.

A risk-averse buyer and seller contract over the trade of an item. At the time of trading, they each privately know their value s and cost r respectively, but these are not known when the contract is drawn up. The contract specifies a Bayesian revelation mechanism for implementing a trading rule and prices, as functions of their type s and r. An optimal (second-best) contract balances the goal of efficient trading and risk sharing against the need to provide the agents with incentives to reveal their type truthfully. In general, it is not monotonic, and so a nonstandard technique has to be used to find the nature of the second-best distortions. Copyright 1988 by The Review of Economic Studies Limited.