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Simple Contracts under Observable and Hidden Actions

Author

Listed:
  • Bo Chen

    (Southern Methodist University, USA)

  • Yu Chen

    (University of Graz, Austria)

  • David Rietzke

    (Lancaster University, UK)

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.

Suggested Citation

  • Bo Chen & Yu Chen & David Rietzke, 2017. "Simple Contracts under Observable and Hidden Actions," Graz Economics Papers 2017-07, University of Graz, Department of Economics.
    • Handle: RePEc:grz:wpaper:2017-07
    as

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    File URL: https://unipub.uni-graz.at/obvugrveroeff/download/pdf/9565005?originalFilename=true
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    First-best Benchmark; Forcing Contract; Forcing Principle; Moral Hazard; Multitask; Observable Actions;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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