48 Pages Posted: 8 Jan 2013 Last revised: 8 Jul 2017
Date Written: June 6, 2017
It is often suggested that incentive schemes under moral hazard can be gamed by an agent with superior knowledge of the environment and that deliberate lack of transparency about the incentive scheme can reduce gaming. We formally investigate these arguments in a two-task moral hazard model in which the agent is privately informed about which task is less costly for him. We examine a simple class of incentive schemes that are "opaque" in that they make the agent uncertain ex ante about the incentive coefficients in the linear payment rule. Relative to transparent menus of linear contracts, these opaque schemes induce more balanced efforts, but they also impose more risk on the agent per unit of aggregate effort induced. We identify specific settings in which optimally designed opaque schemes not only strictly dominate the best transparent menu but also eliminate the efficiency losses from the agent's hidden information. Opaque schemes are more likely to be preferred to transparent ones when (i) efforts on the tasks are highly complementary for the principal; (ii) the agent's privately known preference between the tasks is weak; (iii) the agent's risk aversion is significant; and (iv) the errors in measuring performance have large correlation or small variance.
Keywords: incentives, gaming, contracts, opacity
JEL Classification: D86, D21, L22
Suggested Citation: Suggested Citation
Ederer, Florian and Holden, Richard and Meyer, Margaret, Gaming and Strategic Opacity in Incentive Provision (June 6, 2017). Cowles Foundation Discussion Paper No. 1935. Available at SSRN: https://ssrn.com/abstract=2197597 or http://dx.doi.org/10.2139/ssrn.2197597