Threat-based incentive mechanisms under moral hazard and adverse selection

Abstract

We characterize and show the existence of asymptotically optimal threat-based incentive mechanisms in a principal-agent environment with simultaneous moral hazard and adverse selection and a risk-averse agent. Under certain conditions, such mechanisms approximate an optimal solution derived under pure adverse selection. This is an extension of Mirrlees' scheme (In Essays on Economic Behaviour under Uncertainty, Balch, McFadden, and Wu, Eds. Amsterdam: North-Holland, 1974) in which threat-based incentive contracts approximate a Pareto-optimal solution. Our result, however, seems to provide insight into why, in practice, agents voluntarily participate in, or even help establish, threat-based contractual relationships. We show that it is optimal for the principal to let the agent self-select a target-penalty level and enjoy the full private information rents.