Simple Contracts under Observable and Hidden Actions

Bo Chen (), Yu Chen () and David Rietzke ()
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Bo Chen: Southern Methodist University, USA
Yu Chen: University of Graz, Austria

No 2017-07, Graz Economics Papers from University of Graz, Department of Economics

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 that is essentially outcome-contingent. The forcing contract 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 analytic advantage for the existence and computation of optimal contracts in our setting. It also highlights the importance of the existence of the punishment scheme in characterizing first-best benchmarks in moral hazard problems, which is typically ignored in the literature.

Keywords: First-best Benchmark; Forcing Contract; Forcing Principle; Moral Hazard; Multitask; Observable Actions (search for similar items in EconPapers)
JEL-codes: C61 C62 D82 D86 (search for similar items in EconPapers)
Date: 2017-08
New Economics Papers: this item is included in nep-cta, nep-mic and nep-reg
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