Simple Contracts with Adverse Selection and Moral Hazard

Abstract

We study a principal-agent model with both moral hazard and adverse selection. Risk-neutral agents with limited liability have arbitrary private information about the distribution of outputs and the cost of effort. We obtain conditions under which the optimal mechanism offers a single contract to all types. These conditions are always satisfied, for example, if output is binary or if the distribution of outputs is multiplicatively separable and ordered by FOSD (if it is not ordered, the optimal mechanism offers at most two contracts). If, in addition, the marginal distribution satisfies the monotone likelihood ratio property, this single contract is a debt contract. Our model suggests that offering a single contract may be optimal in environments with adverse selection and moral hazard, where offering flexible menus of contracts provides gaming opportunities to the agent.

Keywords: contract theory, adverse selection, moral hazard, mechanism design