Moral Hazard with Soft Information

Abstract

This paper studies moral hazard where he agent alone observes the stochastic outcome of her action, which she reports to the principal. Therefore the principal also faces a problem of ex post adverse selection, for which an audit is required. Because the problem is not separable, the contract must resolve a fundamental tension between ex ante and ex post incentives. The Revelation Principle must be extended to obtain type separation. The optimal contract features two new frictions: (i) the agent’s ability to exaggerate her performance increases the cost of effort and (ii) bounded penalties further increase that cost by rendering the transfer function option-like. A better audit relaxes both these frictions.