Knightian uncertainty and moral hazard

This paper presents a principal-agent model in which the agent has imprecise beliefs. We model this situation formally by assuming the agentʼs preferences are incomplete as in Bewley (1986) [2]. In this setting, incentives must be robust to Knightian uncertainty. We study the implications of robustn...

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Bibliographic Details
Published in:Journal of economic theory 2011-05, Vol.146 (3), p.1148-1172
Main Authors: Lopomo, Giuseppe, Rigotti, Luca, Shannon, Chris
Format: Article
Language:English
Subjects:
Agency theory
Contract theory
Contracts
Economic models
Economics
Equilibrium
Incomplete preferences
Knightian uncertainty
Knightian uncertainty Moral hazard Contract theory Incomplete preferences
Moral hazard
Studies
Uncertainty
Utility functions
Wages
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Summary:This paper presents a principal-agent model in which the agent has imprecise beliefs. We model this situation formally by assuming the agentʼs preferences are incomplete as in Bewley (1986) [2]. In this setting, incentives must be robust to Knightian uncertainty. We study the implications of robustness for the form of the resulting optimal contracts. We give conditions under which there is a unique optimal contract, and show that it must have a simple flat payment plus bonus structure. That is, output levels are divided into two sets, and the optimal contract pays the same wage for all output levels in each set. We derive this result for the case in which the agentʼs utility function is linear and then show it also holds if this utility function has some limited curvature.
ISSN:0022-0531
1095-7235
DOI:10.1016/j.jet.2011.03.018