Abstract

This paper studies the optimal contract offered by a risk-neutral principal to a risk-averse agent when the agent’s hidden ability and action both improve the probability of the project being successful. We show that if the agent is sufficiently prudent and able, the principal induces a higher probability of success than under moral hazard, despite the costly informational rent given up. Moreover, there is distortion at the top. Finally, the conditions to avoid pooling are difficult to satisfy because of the different kinds of incentives to be managed and the overall trade-off between rent extraction, insurance, and efficiency involved.

Highlights

  • The theory of incentives has made considerable advances in the last forty years

  • We show that moving from the lowest to the highest ability leads the overall trade-off to substitute distortions due to moral hazard for distortions due to adverse selection

  • Pooling is most likely to emerge since the conditions to avoid pooling are more difficult to satisfy because of the different kinds of incentives the principal has to manage and the overall trade-off between rent extraction, insurance, and efficiency involved

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Summary

Introduction

The theory of incentives has made considerable advances in the last forty years. The implications of pure adverse-selection or pure moral-hazard models are well known. there are many examples of contracts designed to solve adverse-selection and moral-hazard problems simultaneously. The notion of sufficiently highly prudent agent will be stated rigorously in the core of the paper It follows that the optimal probability is such that the marginal benefit equals the mixed-model marginal cost, i.e., the sum of the moral-hazard marginal cost and the adverse-selection marginal cost (i.e., the informational-rent marginal cost). In the presence of both a sufficiently highly prudent and a sufficiently able agent, the decrease in the moral-hazard marginal cost more than offsets the adverse-selection marginal cost It follows that the mixed-model contract entails a higher probability of success than the moral-hazard contract, despite the costly informational rent given up. There is a reduction in the probability of success when the agent is imprudent or insufficiently prudent since the informational rent increases the moral-hazard marginal cost due to risk aversion

Related Literature
The Model
Full Information
Moral Hazard Alone
Mixed Model
Fully-Separating Contract
An Example
Distortion at the Top
Sufficiently Highly Prudence
Conclusions

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