Incentive Contracting with Asymmetry of Precontractual Beliefs

Abstract

The interaction between a risk-neutral principal and agent is explored in which the agent's information is better than that of the principal both before and after a contract is agreed upon. It is shown that, in contrast to the case in which precontractual information is symmetric, the final contract between the principal and the agent will usually not be ex post Pareto efficient. The properties of the optimal (set of) contract(s) is derived in detail, and it is shown that the qualitative such properties may vary depending upon whether the random state of nature follows a continuous or a discrete distribution.