Dynamic Screening and the Dual Roles of Monitoring

This paper determines the optimal tenurial contract between a monopoly landlord and a tenant protected by limited liability under both adverse selection (based on the tenant's ability) and moral hazard (based on the tenant's choice of effort). We identify different optimal contracts depending on the tenant's outside option. For intermediate values, there is a threshold of tenant ability depending on the outside option level below which the optimal contract is a separating sharecropping contract, and a pooling one otherwise. We also find that an increase in the outside option does not monotonically increase the tenant's optimal effort.

In spite of the importance of optimal contracting problems under moral hazard and adverse selection, current literature offers no optimal solutions to contracting problems under moral hazard and adverse selection with risk averse agents. The agent's risk aversion, however, appears to be critical for understanding managerial compensation problems. We present a continuous-time agency model with a risk-averse agent and a risk-neutral principal to show that moral hazard and adverse selection can be optimally resolved with a menu of linear contracts. In application, we discuss a few managerial compensation problems involving managerial project selection and capital budgeting decisions, and show that a flat-wage contract is sometimes optimal.

In a team subject to both adverse selection (each member's ability is known only to himself) and moral hazard (effort cannot be observed), optimal contracts are, under certain conditions, linear in the team's output. The outcome is the same whether the principal observes just the total output or each individual's contribution. Thus monitoring is not needed to prevent shirking by team members; instead, the role of monitoring is to discipline the monitor. Production is a collective enterprise: by workers in a firm or firms in a joint venture. The synergy that is the reason for the team's existence may mean that an individual's contribution to the team's output is not distinguishable, so that it is impossible to pay him according to his own productivity. How should the principal remunerate the team members so as to maximize his own profit? In this paper we analyze incentives in teams with asymmetric information: both adverse selection (each member's ability is known only to himself) and moral hazard (effort cannot be observed directly). Holmstrom (1982) showed that, in a team model with moral hazard, the principal can ensure an outcome arbitrarily close to the full-information ideal by using a contract that punishes each team member arbitrarily severely whenever team output falls below some target. However, this seems to be an unrealistically drastic way of solving the moral-hazard problem. In our model, we in effect prevent the principal from using such a contract by introducing adverse selection in addition to moral hazard, and by assuming that ability and effort interact in such a way that the principal is unable to disentangle an agent's effort from his ability. Under the assumption that the principal and the team members are risk neutral, we shall show that the principal can implement his information-constrained optimum simply by offering each agent a payment linear in the team's output. Although the essential feature of our analysis is the interaction between adverse selection and moral hazard, this result can be understood by first considering the special case in which the agents' abilities are common knowledge. In this case the moral-hazard problem can be completely solved: the principal can do as well as he

Optimal contracts under competition when uncertainty from adverse selection and moral hazard are present

This paper analyzes optimal and equilibrium insurance contracts under adverse selection and moral hazard, comparing them with those under a single informational asymmetry. The complex interactions of self-selection and moral hazard constraints have important consequences. We develop an analytic approach that allows a characterization of equilibrium and optimal (Pareto Optimal (PO), and Utilitarian optimal (UO)) allocations. Among the results : (i) a PO allocation may involve shirking (not only less care in accident avoidance than is possible, but less care compared to the case of pure moral hazard) either by high risk individuals in the case of single-crossing preference or by one or both types in the case of multi-crossing preference (as may naturally be the case under the double informational asymmetry); and (ii) while an equilibrium, which is unique (even under multi-crossing preferences) if it exists, is more likely to exist as the non-shirking constraint for low-risk type gets more stringent (i.e. when low risk individuals shirk with lower levels of insurance). We also show that a pooling equilibrium, which is not feasible under pure adverse selection, may exist when individuals differ in risk aversion (as well as in accident probability) or when the provision of insurance is non-exclusive (i.e. individuals can purchase insurance from more than one firm). Furthermore, while with pure adverse selection, UO always entails pooling with complete insurance (in the standard model), with adverse selection and moral hazard, all PO allocations may entail separation and the UO may entail incomplete insurance. We show further that, in general, any PO allocation can be implemented by a basic pooling insurance provided by the government and a supplemental separating contracts that can be offered by the market, although, in the presence of moral hazard, a tax needs to be imposed upon the market provision. The analysis suggests that two commonly observed features of many countries' public insurance schemes are consistent with PO: (a) Some individuals (type H) shirk--contrary to widespread views, it is not a sign of a poorly designed system that some individuals shirk; and (b) there exists a hybrid provision of insurance by the government and the market.

This paper studies a principal-agent relationship when both are risk-neutral and in the presence of adverse selection and moral hazard. Contracts must satisfy the limited-liability and monotonicity conditions. We provide sufficient conditions under which the optimal contract is simple, in the sense that each type is offered the same contract. These are: the action and the agent’s type are complements, and the output’s cumulative distribution function is such that the marginal rate of substitution between the action and the agent’s type is the same for each possible output realization. Furthermore, under the average monotone likelihood ratio property, the optimal contract is a call-option contract as in Innes (J Econ Theory 52(1):45–67, 1990). The results shed light on the fact that sometimes contracts are not highly dependent on individual characteristics as predicted in most pure moral hazard and pure adverse selection settings.

This thesis investigates how the theoretical predictions of traditional economic models change when the assumption of Bayesian decision making is relaxed. Bayesian decision theory assumes that decision makers are able to perfectly describe their state space and assign a single prior to every possible event. The theory of unawareness relaxes the first assumption by allowing decision makers to be aware of some contingencies and unaware of others. The theory of ambiguity relaxes the second assumption and allows decision makers to prefer known risks over unknown risks. The first chapter of this thesis analyzes the effect of ambiguity on bilateral trade in the presence of private information. It demonstrates that in an environment with adverse selection as in Akerlof’s (1970) market for lemons, screening the informed party hedges against ambiguity. It further shows that the presence of ambiguity can be both beneficial or harmful for trade. If the adverse selection problem is sufficiently severe, more ambiguity surprisingly leads to more trade and thereby increase surplus. Using these results, a financial market application demonstrates that ambiguity may help to explain why some assets are optimally traded over-the-counter rather than on traditional exchanges, and suggests that opacity may be essential to sustain such trade. The second chapter of this thesis introduces asymmetric awareness into a classical principal-agent model with moral hazard, and shows how unawareness can give rise to incomplete contracts.1 The paper investigates the optimal contract between a fully aware principal and an unaware agent, where the principal can enlarge the agent’s awareness strategically. When proposing the contract, the principal faces a tradeoff between participation and incentives: leaving the agent unaware allows the principal to exploit the agent’s incomplete understanding of the world, relaxing the participation constraint, while making the agent aware enables the principal to use the revealed contingencies as signals about the agent’s action choice, relaxing the incentive constraint. The optimal contract reveals contingencies that have low probability but are highly informative about the agent’s effort. This paper was published in Games and Economic Behavior, Vol.82, 2013.

This article aims to study lease and hiring contract in the Iranian-Islamic setting and analyze the asymmetric information problem in these contracts. For doing this, we study the characteristics of lease and hiring contracts in Iran (real world experimental characteristics that recognized in other studies), using library method, then we mathematically model different aspects of asymmetric information (hidden information and hidden action) using contract theory. The result of model indicates that there is a list of optimal contracts in any lease or hiring transactions that can solve asymmetric information problems (adverse selection and moral hazard) by satisfying the participation and incentive compatibility constraints. Finally in the experimental analyses we calculate the optimal contract with hypothetical parameters using lingo software and illustrate that the main models provided for every transactions is solvable and the optimal contracts are obtainable. Experimental contracts shows that the lessor has to set security deposits of tenant type θL lower than tenant type θH and set higher monthly rent for him in lease contracts, and principal has to set wage of tenant type θL lower than tenant type θH and set higher length of contract for him in hiring contracts to solve asymmetric information problems.

In a continuous-time setting where a risk-averse agent controls the drift of an output process driven by a Brownian motion, optimal contracts are linear in the terminal output; this result is well-known in a setting with moral hazard and { under stronger assumptions { adverse selection. Using techniques from stochastic control theory, we show that this result continues to hold when in addition reservation utilities are type-dependent. This type of problem occurs in the study of optimal compensation problems involving competing principals.

We investigate the design of optimal incentive mechanism under adverse selection and moral hazard with risk neutral principal and agents.The optimal incentive payment contract is derived.The interesting comparative statics of the optimal incentive contract are analyzed.First, we show that the optimal level of effort is an increasing function of the ability of agent and less than the one in symmetric information. Second, the optimal incentive wage contracts are Composed of a fixed income and performance related income. The fixed-income part of the optimal incentive contract is an increasing function of type. We also show that high ability agent obtain higher wage in success and lower one in failure than low ability agent for the performance related income.

In this paper, we study the problem in which a risk-neutral principal design optimal incentive wage contracts for a risk-averse agent under asymmetric information.Using the theories and methods of dynamic programming and optimal control and mechanism design,the characteristics and some interesting comparative static of optimal linear incentive wage contracts have been obtained in simultaneous adverse selection and moral hazard .we show that the higher the capacity of an agent, he was more hard work. Moreover,the optimal contract for the higher ability agent is higher energy incentive or higher risk for screening the ability of agents.

This article presents a continuous-time agency model in the presence of adverse selection and moral hazard with a risk-averse agent and a risk-neutral principal. Under the model setup, we show that the optimal controls are constant over time, and thus the optimal menu consists of contracts that are linear in the final outcome. We also show that when a moral hazard problem adds to an adverse selection problem, the monotonicity condition well known in the pure adverse selection literature needs to be modified to ensure the incentive compatibility for information revelation. The model is applied to a few managerial compensation problems involving managerial project selection and capital budgeting decisions. We argue that in the third-best world, the relationship between the volatility of the outcome and the sensitivity of the contract depends on interactions between the managerial cost and the firm's production functions. Contrary to conventional wisdom, sometimes the higher the volatility, the higher the sensitivity of the contract. The firm receiving good news sometimes chooses safer projects or invests less than it does with bad news. We also examine the effects of the observability of the volatility on corporate investment decisions. Copyright 2005, Oxford University Press.

Adverse selection and moral hazard: Quantitative implications for unemployment insurance

This article models the process of bidding for government contracts in the presence of moral hazard. Several (possibly risk-averse) potential contractors (agents) submit sealed bids, on the basis of which the government (principal) selects one to perform a task. The optimal linear contract is derived. The bidding process induces the potential agents to reveal their relative expected costs. The optimal contract trades off giving the chosen agent an incentive to limit costs against stimulating bidding competition and sharing risks. The optimal contract is never cost-plus, may befixed-price, but is usually an incentive contract. Some prescriptions for government contracting emerge. * When the government offers a contract for a project such as the construction of a road or a warship, it usually calls for bids from interested firms and selects the lowest bidder. There are several informational asymmetries in this process. The government cannot directly observe any bidder's expected production costs, and therefore it does not know which is the efficient firm. Each bidder must determine his bid in ignorance of the expected costs of his rivals. After a bidder has been selected, he is better informed than the government about the vagaries of the particular project; thus, the government is unable to observe how much effort the firm is making to limit production costs. The government must design a contract to address both adverse selection (the government does not know the expected cost of any firm) and moral hazard (the government cannot observe the selected firm's effort to keep its realized production costs low). To complicate matters, if the firms are risk averse, it is in the government's interest to offer a contract in which the government bears some of the risk of unpredictable cost fluctuations. The forms of contract used in practice by governments make the payment to the contractor a linear function of its bid and/or its realized costs. With a fixed-price contract, the payment is simply the firm's bid. With a cost-plus contract, the government agrees to cover completely the costs incurred by the contractor, plus pay a fee that is either fixed in advance or is a proportion of costs. An incentive contract makes the payment depend both on the bid and on realized costs: if realized costs exceed the firm's bid, the firm is responsible for

Radio frequency (RF) powered cognitive radio networks (CRNs) integrated with ambient backscatter technology is a newborn communication scheme. However, the time allocation is still an important issue that limits the performance of this system seriously. Unlike the centralized distribution methods under complete information in previous studies, in this paper, we introduce a financing contract mechanism to solve the time allocation problem with strongly incomplete information, where the primary user (PU) only knows the probability distribution of each secondary transmitter’s (ST’s) type. In this contract, the PU and SUs act as the seller and buyers, respectively. The mutually beneficial relationships between the PU and SUs can be linked with the signed contract about the amount of the signal transmitting time and the payment. Then, we discuss three cases where either or both adverse selection and moral hazard are present due to the information asymmetry. Moreover, the optimal contracts under three scenarios are further formulated and solved by using the Lagrangian multiplier method. Finally, simulation results show that compared with the case of complete information the contract with adverse selection and moral hazard has a small performance loss, which is acceptable on account of the practical superiority of the strongly incomplete information case.