Hunting with Two Bullets: Moral Hazard with a Second Chance
FEUNL Working Paper Series No. 629
34 Pages Posted: 30 Aug 2018 Last revised: 1 Dec 2018
Date Written: November 28, 2018
I study the moral hazard problem where an agent can create an extra instance of effort and potentially improve bad realizations of the outcome before the principal observes it. The agent cannot hide the outcome of his effort, but just the way he achieved it. Findings are that both, principal and agent, value the option of improving the outcome in case of a bad realization if doing so is cheap. I also find that contracted effort is not always decreasing in its cost. I also study the situation in which, if the principal can impose short deadlines and eliminate the agent's extra chance, under a broad range of scenarios, the principal will do so when the parameters make agency costs sufficiently high. Finally, if the creation of the extra instance can cause a punishment for the principal, and if that punishment is sufficiently big, the principal will avoid writing contracts that incentive effort only on the extra chance.
Keywords: Moral Hazard, Asymmetric Information, Contract Theory, Second Chance
JEL Classification: D82, D86
Suggested Citation: Suggested Citation