The Principal-Agent Relationship with an Informed Principal, II: Common Values

Abstract

In many circumstances, a principal may have relevant private information when she proposes a contract to an agent. We analyze such a principal-agent relationship as a noncooperative game. The principal proposes a contract, which is accepted or rejected by the agent (who, for most of our analysis, has no private information). The contract is executed if accepted; otherwise, the reservation allocation takes effect. This allocation may be determined by a pre-existing contract (which the principal, by her proposal, is attempting to renegotiate), or it may simply be the no-trade point. In this paper, we assume that the principal's information directly affects the agent's payoff. Before solving the game, we discuss Pareto efficiency with asymmetric information. We define an incentive-compatible allocation to be weakly interim efficient (WIE) if there exists no alternative incentive-compatible allocation that both parties prefer for all possible beliefs that the agent might have about the principal's private information (type). We show that any WIE allocation is interim-efficient (IE) for some beliefs. The Rothschild-Stiglitz-Wilson (RSW) allocation relative to the reservation allocation /.L is the allocation that maximizes the payoff of each type of principal within the class of incentive-compatible allocations that guarantee the agent at least the utility he gets from A' irrespective of his beliefs about the principal's type. The equilibrium set of the contract proposal game consists of the allocations that weakly Pareto dominate the RSW allocation. Thus, there is a unique equilibrium outcome if and only if the latter is IE (and the equilibrium outcome is the RSW allocation itself). After characterizing the equilibrium allocations, we study those that are renegotiation-proof, when either the principal or the agent leads the renegotiation. We then compare our contract proposal game, which is a signaling model, with its screening counterpart. We conclude by extending our results to the case in which the agent as well as the principal has private information under the assumption of quasi-linear preferences.