Contracting Timely Delivery with Hard to Verify Quality

Abstract

I study a continuous-time principal-agent model with hidden effort and imperfect monitoring about project quality. I consider a situation in which the agent can manipulate output so as to reduce the completion time of a project at the expense of quality. In order to deter manipulation the principal must make payments contingent on the subsequent performance of the project. The principal balances the provision of incentives to exert effort and the cost of deferring compensation. Unlike in previous models with pure moral hazard, the agent may never be terminated. Moreover, if the optimal contract requires termination, this must be unpredictable. If this were not the case the agent would manipulate performance when he is close to being fired. I analyze the case in which the principal can commit to a mixed strategy of termination, and also where the principal cannot commit to terminate the agent. In the latter case, the mixed strategy of termination has to be incentive compatible for the principal. In the optimal contract, cash compensation is deferred longer than in the absence of manipulation. Finally, I observe that contracts have longer duration when quality is more difficult to observe.