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Xi Chen (), Yu Chen () and Xuhu Wan ()
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Xi Chen: Nanjing University, China
Yu Chen: University of Graz, Austria
Xuhu Wan: Hong Kong University of Science and Technology, Hong Kong

No 2018-11, Graz Economics Papers from University of Graz, Department of Economics

Abstract: This paper explores a new continuous-time principal-agent problem for a firm with both moral hazard and adverse selection. Adverse selection appears at random times. The agent finds projects sequentially by exerting costly effort. Each project brings output to the firm, subject to the agent’s private shocks. These serial shocks are i.i.d and independent of the arrival time of new projects and the agent’s efforts. The shocks and efforts constitute the agent’s asymmetric information. We provide a full characterization of optimal contracts in which moral hazard effect and adverse selection effects interact. The second-best contract with moral hazard can achieve first-best efficiency, and third-best contract with the moral hazard and adverse selection can achieve second-best efficiency under pure adverse selection, if the agent is expectably rich enough. The payment is front-loaded under pure moral hazard. When moral hazard is combined with adverse selection, the payment can be backloaded or front-loaded, depending on the level of expectable wealth.

Keywords: Dynamic Contract; Continuous Time; Moral Hazard; Adverse Selection; Project Search (search for similar items in EconPapers)
JEL-codes: C61 D82 D86 J30 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cta, nep-hrm, nep-mic and nep-ppm
Date: 2018-05
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