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The Optimal Contract under Adverse Selection in a Moral-Hazard Model with a Risk-Averse Agent

François Maréchal () and Lionel Thomas ()
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François Maréchal: CRESE EA3190, University Bourgogne Franche-Comté, F-25000 Besançon, France
Lionel Thomas: CRESE EA3190, University Bourgogne Franche-Comté, F-25000 Besançon, France

Games, 2018, vol. 9, issue 1, 1-22

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.

Keywords: adverse selection; moral hazard; risk aversion; prudence (search for similar items in EconPapers)
JEL-codes: C C7 C70 C71 C72 C73 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:gam:jgames:v:9:y:2018:i:1:p:12-:d:134141