On the Interplay of Hidden Action and Hidden Information in Simple Bilateral Trading Problems

Abstract

Consider the following situation. There are two parties, a buyer who is interested in one unit of a specific good, and a seller who can produce this good for the buyer. While producing the good, the seller can exert more or less unobservable effort (hidden action). When the buyer sees the finished product, he privately realizes whether his willingness-to-pay for the good is high or low (hidden information). There are no third parties, no liability constraints, and both parties are risk-neutral. What kind of contract should they write? Although this seems to be one of the most basic and natural problems a contract theorist might think of, it has not yet been explicitly analyzed in the literature. It is shown here 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.

Keywords: hidden action, hidden information, moral hazard

JEL Classification: C72, C78, D23, D82