Imprecise Beliefs in a Principal Agent Model

Abstract

This paper presents a principal-agent model where the agent has multiple, or imprecise, beliefs. We model this situation formally by assuming the agent's preferences are incomplete. One can interpret this multiplicity as an agent's limited knowledge of the surrounding environment. In this setting, incentives need to be robust to the agent's different beliefs. We study whether robustness implies simplicity. Under mild conditions, we show the unique optimal contract has a two-wage structure; a flat payment and bonus. That is, all output levels are divided into two groups, and the optimal incentive scheme pays the same amount for all output levels in each group. We also show that a two-state two-action framework can be thought of as a reduced form of the original model. We solve explicitly the principal's problem in this case, and discuss some implications of our model for firm ownership.