On the Interplay of Hidden Action and Hidden Information in Simple Bilateral Trading Problems
Patrick W. Schmitz
University of Cologne; Centre for Economic Policy Research (CEPR)
A buyer and a seller can exchange one unit of an indivisible good. While producing the good, the seller can exert unobservable effort (hidden action). Then the buyer realizes whether his valuation is high or low, which stochastically depends upon the seller's effort level (hidden information). The parties are risk neutral, they can rule out renegotiation and write complete contracts. It is shown that the first best cannot be achieved whenever the ex post efficient trade decision is trivial. The second-best contract is characterized and an application of the model to the choice of risky projects is briefly discussed.
Number of Pages in PDF File: 21
Keywords: hidden action, hidden information, moral hazard
JEL Classification: C72, C78, D23, D82working papers series
Date posted: December 17, 2002
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