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Principal-agent problems with adverse selection: A stochastic target problem formulation

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  • Guillermo Alonso Alvarez
  • Ibrahim Ekren
  • Liwei Huang

Abstract

We study a principal-agent problem with adverse selection, where the principal does not know the agent's true cost but must design a contract to optimize a specific criterion. Unlike standard screening frameworks that allow for self-selection, we assume the principal can only offer a unique contract. We show that the agent's optimization problem can be reformulated as a stochastic target problem. After characterizing the credible domain of this target problem, we show that the principal's objective can be solved as a stochastic optimal control problem with partial information and state constraints. The description of the credible domain also allows us to obtain the value of screening contracts.

Suggested Citation

  • Guillermo Alonso Alvarez & Ibrahim Ekren & Liwei Huang, 2026. "Principal-agent problems with adverse selection: A stochastic target problem formulation," Papers 2605.01080, arXiv.org, revised May 2026.
    • Handle: RePEc:arx:papers:2605.01080
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    References listed on IDEAS

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