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Optimal contracts when the players think differently

Author

Listed:
  • Martin Dumav

    (Universidad Carlos III de Madrid)

  • Urmee Khan

    (University of California Riverside)

  • Luca Rigotti

    (University of Pittsburgh)

Abstract

In a canonical moral hazard problem with probabilistic but heterogeneous beliefs, we revisit existing results regarding first-best contracts and give a fair warning regarding the monotonicity of second-best contracts. We show that the standard monotonicity result with homogeneous beliefs extends to belief heterogeneity when the agent is more optimistic than the principal. However, in the reverse case—when the principal is more optimistic—the optimal contract can be non-monotone, breaking the link between compensation and performance.

Suggested Citation

  • Martin Dumav & Urmee Khan & Luca Rigotti, 2025. "Optimal contracts when the players think differently," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 80(3), pages 863-890, November.
    • Handle: RePEc:spr:joecth:v:80:y:2025:i:3:d:10.1007_s00199-025-01646-4
    DOI: 10.1007/s00199-025-01646-4
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    References listed on IDEAS

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    1. Ulrike Malmendier & Timothy Taylor, 2015. "On the Verges of Overconfidence," Journal of Economic Perspectives, American Economic Association, vol. 29(4), pages 3-8, Fall.
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    3. Martin Dumav & Urmee Khan & Luca Rigotti, 2025. "Optimal contracts when the players think differently," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 80(3), pages 863-890, November.
    4. Auster, Sarah, 2013. "Asymmetric awareness and moral hazard," Games and Economic Behavior, Elsevier, vol. 82(C), pages 503-521.
    5. Ying Fan & A. Yeşim Orhun & Dana Turjeman, 2020. "Heterogeneous Actions, Beliefs, Constraints and Risk Tolerance During the COVID-19 Pandemic," NBER Working Papers 27211, National Bureau of Economic Research, Inc.
    6. de la Rosa, Leonidas Enrique, 2011. "Overconfidence and moral hazard," Games and Economic Behavior, Elsevier, vol. 73(2), pages 429-451.
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    1. Martin Dumav & Urmee Khan & Luca Rigotti, 2025. "Optimal contracts when the players think differently," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 80(3), pages 863-890, November.
    2. de la Rosa, Leonidas Enrique & Lambertsen, Nikolaj Niebuhr, 2025. "Overconfidence and moral hazard without commitment," Journal of Mathematical Economics, Elsevier, vol. 119(C).
    3. Nikolaj Niebuhr Lambertsen, 2025. "Exploiting overconfidence: optimal contracts with heterogeneous beliefs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 79(4), pages 1225-1254, June.

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    Keywords

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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