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Flexible Contracts

  • Piero Gottardi
  • Jean Marc Tallon
  • Paolo Ghirardato

This paper studies the costs and benefits of delegating decisions to superiorly informed agents relative to the use of rigid, non discretionary contracts. Delegation grants some flexibility in the choice of the action by the agent, but also requires the use of an appropriate incentive contract so as to realign his interests with those of the principal. The parties’ understanding of the possible circumstances in which actions will have to be chosen and their attitude towards risk and uncertainty play then an important role in determining the costs of delegation. The main focus of the paper lies indeed in the analysis of these costs and the consequences for whether or not delegation is optimal. We determine and characterize the properties of the optimal flexible contract both when the parties have sharp probabilistic beliefs over the possible events in which the agent will have to act and when they only have a set of such beliefs. We show that the higher the agent’s degree of risk aversion, the higher the agency costs for delegation and hence the less profitable is a flexible contract versus a rigid one. The agent’s imprecision aversion in the case of multiple priors introduces another, additional agency costs; it again implies that the higher the degree of imprecision aversion the less profitable flexible contracts versus rigid ones. Even though, with multiple priors, the contract may be designed in such a way that principal and agent end up using ’different beliefs’ and hence engage in speculative trade, this is never optimal, in contrast with the case where the parties have sharp heterogeneous beliefs.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2009/34.

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Date of creation: 2009
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Handle: RePEc:eui:euiwps:eco2009/34
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  1. Itzhak Gilboa & David Schmeidler, 1989. "Maxmin Expected Utility with Non-Unique Prior," Post-Print hal-00753237, HAL.
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  7. Jullien, B. & Salanie, B. & Salanie, F., 1998. "Should More Risk-Averse Agents Exert More Effort?," Papers 98.489, Toulouse - GREMAQ.
  8. Rantakari Heikki V, 2008. "On the Role of Uncertainty in the Risk-Incentives Tradeoff," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 8(1), pages 1-25, April.
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  15. Mukerji, Sujoy & Tallon, Jean-Marc, 2004. "Ambiguity aversion and the absence of wage indexation," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 653-670, April.
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  17. Armstrong, Mark & Vickers, John, 2008. "A model of delegated project choice," MPRA Paper 8963, University Library of Munich, Germany.
  18. Michael Raith, 2008. "Specific knowledge and performance measurement," RAND Journal of Economics, RAND Corporation, vol. 39(4), pages 1059-1079.
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  20. Ernst Fehr & Oliver Hart & Christian Zehnder, 2008. "Contracts as reference points � experimental evidence," IEW - Working Papers 393, Institute for Empirical Research in Economics - University of Zurich.
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  26. Oliver Hart & John Moore, 2008. "Contracts as Reference Points," The Quarterly Journal of Economics, Oxford University Press, vol. 123(1), pages 1-48.
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