Optimal Contracts under Moral Hazard, Adverse Selection and Limited Liability

A buyer (the principal) procures a good or service from a risk-neutral seller (the agent). The seller, protected by limited liability, has private information on his marginal cost of production (adverse selection), and exerts a non-verifiable effort that increases surplus (moral hazard). Even when the effort and production technologies are separable, the optimal contract always mixes features that are found separately under with pure moral hazard or pure screening. Screening distortions are mitigated in comparison with the pure screening scenario with the possibility of bunching for the least efficient types even in contexts where full separation would be obtained with pure screening. Effort distortions are also used as a screening device. In comparison with a pure moral hazard scenario, those distortions may be lessened for the most efficient types, up to the point of possibly allowing implementation of the first-best effort, while they are worsened for the worst types. Although our analysis is cast in a simple procurement setting, we illustrate our findings in other economic environments of general interest including economic and environmental regulation, financial contracting, provision of quality in services, and price discrimination.