Production Externalities and Two-way Distortion in Principal-multi-agent Problems

Abstract

This paper studies an otherwise standard principal-agent problem with hidden information, but where there are positive production externalities between agents: the output of any agent depends positively on the effort expended by other agents. It is shown that the optimal contract for the principal exhibits two-way distortion: the effort of any agent is oversupplied (relative to the first-best) when his marginal cost of effort is low, and undersupplied when his marginal cost of effort is high. This pattern of distortion cannot otherwise arise in optimal single- or multi-agent incentive contracts, unless there are countervailing incentives. However, unlike the countervailing incentives case, the pattern of distortion we find is robust to the precise form of the externality. Journal of Economic Literature Classification Numbers: D21, D28.