Optimal Linear Contract Research Articles

Optimal linear contracts with heterogeneous agents

This paper examines the class of linear contracts in a simple principal–agent model in which agents are heterogeneous in their abilities to perform a task for the principal. We show that in the absence of transaction costs, the optimal linear contract is a set of individualised contracts. The fact that individualised contracts are rarely observed may be explained by the presence of transaction costs. The equilibrium that emerges depends on the costs of screening relative to the heterogeneity in agents' abilities. In the monopsony case, the dynamic incentives of the agents preclude individualised contracts even if transaction costs are not significant.

Optimal retail lease contracts: the principal-agent approach

This paper considers retail lease contracts that are common in practice in a principal-agent framework. The key question concerns whether the optimal linear lease contract should have both the fixed rent and the percentage rent linear in sales. The analysis shows that an optimal linear risk-sharing contract is a form of the pure percentage rent if the tenant is risk averse and the landlord is risk neutral. However, an optimal linear contract that provides incentives for effort and shares risk may include the percentage rent and the fixed rent as well.

Incentive efficiency of compensation based on accounting and market performance

This paper analyzes how earnings and price are used in executive compensation contracts. Risk-averse shareholders collectively design a contract and individually trade in the stock market. In the optimal linear contract the use of earnings and price depends critically on incentive efficiency, i.e., how precisely the measures convey the true outcome. The relative weight of price to earnings exaggerates the true relative importance of price because price impounds traders' overall information while its informational value lies in the incremental information it provides. The use of price allows shareholders to share trading risks with managers.

Monitoring of Performance in Organizational Contracting: The Case of Defense Procurement

This paper contains an agency-theoretic analysis of procurement contracts in which the government designs optimal linear contracts for a risk-averse supplier in the presence of moral hazard, private information and imperfect monitoring. Optimal contracts deviate from first-best risk sharing. The direction of the deviation depends on the relative severity of the moral hazard and private information problems and on the precision of the monitor. In contrast to the usual result in the moral hazard literature, the government may in some cases prefer that the effort of the supplier be taxed. Choice of the precision of the monitor and the categories of costs covered by the monitor are also studied.

Bidding for Contracts: A Principal-Agent Analysis

This article models the process of bidding for government contracts in the presence of moral hazard. Several (possibly risk-averse) potential contractors (agents) submit sealed bids, on the basis of which the government (principal) selects one to perform a task. The optimal linear contract is derived. The bidding process induces the potential agents to reveal their relative expected costs. The optimal contract trades off giving the chosen agent an incentive to limit costs against stimulating bidding competition and sharing risks. The optimal contract is never cost-plus, may befixed-price, but is usually an incentive contract. Some prescriptions for government contracting emerge. * When the government offers a contract for a project such as the construction of a road or a warship, it usually calls for bids from interested firms and selects the lowest bidder. There are several informational asymmetries in this process. The government cannot directly observe any bidder's expected production costs, and therefore it does not know which is the efficient firm. Each bidder must determine his bid in ignorance of the expected costs of his rivals. After a bidder has been selected, he is better informed than the government about the vagaries of the particular project; thus, the government is unable to observe how much effort the firm is making to limit production costs. The government must design a contract to address both adverse selection (the government does not know the expected cost of any firm) and moral hazard (the government cannot observe the selected firm's effort to keep its realized production costs low). To complicate matters, if the firms are risk averse, it is in the government's interest to offer a contract in which the government bears some of the risk of unpredictable cost fluctuations. The forms of contract used in practice by governments make the payment to the contractor a linear function of its bid and/or its realized costs. With a fixed-price contract, the payment is simply the firm's bid. With a cost-plus contract, the government agrees to cover completely the costs incurred by the contractor, plus pay a fee that is either fixed in advance or is a proportion of costs. An incentive contract makes the payment depend both on the bid and on realized costs: if realized costs exceed the firm's bid, the firm is responsible for