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Knightian uncertainty and moral hazard

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  • Lopomo, Giuseppe
  • Rigotti, Luca
  • Shannon, Chris

Abstract

This paper presents a principal-agent model in which the agent has imprecise beliefs. We model this situation formally by assuming the agent[modifier letter apostrophe]s 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 agent[modifier letter apostrophe]s utility function is linear and then show it also holds if this utility function has some limited curvature.

Suggested Citation

  • Lopomo, Giuseppe & Rigotti, Luca & Shannon, Chris, 2011. "Knightian uncertainty and moral hazard," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1148-1172, May.
    • Handle: RePEc:eee:jetheo:v:146:y:2011:i:3:p:1148-1172
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    References listed on IDEAS

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    1. Luca Rigotti & Chris Shannon, 2005. "Uncertainty and Risk in Financial Markets," Econometrica, Econometric Society, vol. 73(1), pages 203-243, January.
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