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Robust Contracting with Additive Noise

Jul 2016
Working Paper
By  Gabriel Carroll, Delong Meng

We investigate the idea that linear contracts are reliable because they give the same incentives for eort at every point along the contract. We ask whether this reliability leads to a microfoundation for linear contracts, when the principal is prot-maximizing. We consider a principal-agent model with risk neutrality and limited liability, in which the agent observes the realization of a mean-zero shock to output before choosing how much eort to exert. We show that such a model can indeed provide a foundation for reliable contracts, and illustrate what elements are required. In particular, we must assume that the principal knows a lower bound, but not an upper bound, on the shocks.

Publication Keywords: 
Linear contract
Principal-agent problem