Simple contracts under observable and hidden actions

Bo Chen (), Yu Chen and David Rietzke ()
Additional contact information
Bo Chen: Southern Methodist University
Yu Chen: University of Graz
David Rietzke: Lancaster University

Economic Theory, 2020, vol. 69, issue 4, No 5, 1023-1047

Abstract: Abstract We consider a general framework for multitask moral hazard problems with observable and hidden actions. Ideally, the principal in our framework can design optimal contracts that depend on both observable (and verifiable) actions and realized outcomes. Given a mild assumption on the existence of a punishment scheme, we identify a general equivalence result, dubbed the “forcing principle,” which states that every optimal contract in our framework is strategically equivalent to a simple forcing contract, which only specifies an outcome-contingent reward scheme and an action profile, and the agent receives the outcome-contingent reward only if he follows the recommended observable actions (and is otherwise punished severely). The forcing principle has useful implications: it confers analytical advantage for the existence and computation of optimal contracts in our setting. It also highlights and makes explicit the importance of the existence of the punishment scheme in characterizing first-best benchmarks in moral hazard problems.

Keywords: First-best benchmark; Forcing contract; Forcing principle; Moral hazard; Observable actions (search for similar items in EconPapers)
JEL-codes: C61 C62 D86 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s00199-019-01187-7

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