Screening Versus Sorting in a Principal-Agent Model with Moral Hazard and Adverse Selection

50 Pages Posted: 16 Mar 2010

See all articles by Rajiv D. Banker

Rajiv D. Banker

Temple University - Department of Accounting

Shaopeng Li

Independent

Jose M. Plehn-Dujowich

Powerlytics. Inc.

Multiple version iconThere are 2 versions of this paper

Date Written: December 13, 2009

Abstract

This paper proposes a principal-agent model of moral hazard and adverse selection that introduces the notion of screening, which is distinct from sorting; and distinguishes between ability that is privately known by the agent versus general ability that is observable by the principal and market. Sorting is the traditional process by which the adverse selection problem is resolved. Screening is the process we propose by which agents that are deemed to be unsuitable are rejected. Used in conjunction with sorting, we consider ex-ante screening on the basis of the measure of general ability; and ex-post screening on the basis of the private measure of ability. We find that the principal may favor an agent with high or low general ability, but always prefers an agent with superior private ability. We derive the properties of the ex-ante and ex-post screening rules as they relate to the characteristics of the principal-agent relationship. Surprisingly, a positive relationship between the private and general measures of ability tends to imply that general ability has a negative effect on the incentives and compensation of the agent, as well as the expected outcome and profit of the firm. Finally, we discuss the econometric methods by which empirical studies of executive compensation should be adjusted to take into account the fact that CEOs were selected for their positions.

Suggested Citation

Banker, Rajiv D. and Li, Shaopeng and Plehn-Dujowich, Jose M., Screening Versus Sorting in a Principal-Agent Model with Moral Hazard and Adverse Selection (December 13, 2009). Available at SSRN: https://ssrn.com/abstract=1570706 or http://dx.doi.org/10.2139/ssrn.1570706

Rajiv D. Banker

Temple University - Department of Accounting ( email )

Philadelphia, PA 19122
United States

Shaopeng Li

Independent

No Address Available

Jose M. Plehn-Dujowich (Contact Author)

Powerlytics. Inc. ( email )

P.O. Box 164
Mechanicsville, PA 18934
United States

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