Information Economics

• Hidden action - the principal cannot observe how much effort the agent exerts = moral hazard
• Hidden information: the agent discovers the profitability of opportunities that the principal cannot observe
• when effort is observable and contractible, a contract specifies that agent's effort and the wage scheme - incentive constraint ignored, participation constraint binds
• when effort is unobservable and the agent is risk averse, incentives for high effort can be provided only at the cost of risk to the agent - participation and incentive constraint are binding
• objectives of the contract: risk neutral owner insures the manager against fluctuations in income, managerial effort should respond to the true disutility of effort theta
• we can restrict the type of contract offered to a direct mechanism that induces truth-telling without loss of generality