Optimal Contracts under Moral Hazard and Adverse Selection: A Continuous-Time Approach

Abstract

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.