Endogenous Selection and Moral Hazard in Compensation Contracts

Christopher D. Armstrong, David F. Larcker and Che-Lin Su
Additional contact information
Christopher D. Armstrong: University of Pennsylvania
David F. Larcker: Stanford University

Research Papers from Stanford University, Graduate School of Business

Abstract: The two major paradigms in the theoretical agency literature are moral hazard (i.e., hidden action) and adverse selection (i.e., hidden information). Prior research typically solves these problems in isolation, as opposed to simultaneously incorporating both adverse selection and moral hazard features. We formulate two complementary generalized principal-agent models that incorporate features observed in real world contracting environments (e.g., agents with power utility and limited liability, lognormal stock price distributions, and stock options) as mathematical programs with equilibrium constraints (MPEC). We use state- of-the-art numerical algorithms to solve the resulting models. We find that many of the standard results no longer obtain when wealth effects are present. We also develop a new measure of incentives calculated as the change in the agent's certainty equivalent under the optimal contract for a change in action evaluated at the optimal action. This measure facilitates interpretation of the resulting contracts and allows us to compare contracts across different contracting environments.

JEL-codes: C60 C61 J33 M52 (search for similar items in EconPapers)
Date: 2010-02
New Economics Papers: this item is included in nep-bec, nep-cmp and nep-cta
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Journal Article: Endogenous Selection and Moral Hazard in Compensation Contracts (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:stabus:2049

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