Optimal contracting with private knowledge of wealth and ability (Q2729258)

The authors investigate properties of an optimal contract between a principal and an agent. The principal owns a project which requires the agent's unobservable efforts. The agent knows from the outset about his wealth and his ability required to operate the project. The principal's optimal strategy is to assign to the agent a contract from a menu of rewards according to his announced ability and wealth. After selecting his preferred contract, the agent chooses his effort supply to maximize his expected profit from production. Then success or failure is observed, and the principal delivers the promised payment. In such a setting the authors found that, contrary to what the conventional wisdom may suggest, greater wealth or greater ability alone do not necessarily enhance the power of the incentive scheme under which the agent operates. Greater wealth and higher ability are both required to ensure the agent is compensated more highly for success. Also, asymmetric knowledge of wealth and ability can render the two productive inputs perfectly complementary, and lead to their pronounced under-utilization.