Rewarding success and failure: moral hazard and adverse selection in strategic experimentation

Abstract

A principal hires an agent to learn about the cost of a project via a series of experiments and then to execute it (production). The agent is privately informed about the probability that the cost is low, with the high-type agent earning rent because he is more optimistic than the low type. In each experiment, the agent privately chooses his effort. The joint presence of adverse selection and moral hazard makes it possible for the low type to “double deviate” by misrepresenting his type and shirking during experimentation. This leads to both truth-telling constraints being binding. The principal uses the length and outcomes of experimentation as well as the timing of payments to screen the agent by rewarding the low type after failure in experimentation. We provide sufficient conditions for both success and failure to be rewarded. We derive the optimality of over experimentation as it makes it less likely that the agent produces without uncovering the true cost and reduces the asymmetric information after a series of failed experiments. We also consider whether it may be optimal to separate experimentation and production between two different agents. Having the same agent working on both tasks enables the principal to use the adverse selection rent to address moral hazard. Therefore, integrating experimentation and production is optimal when adverse selection is severe.

Keywords: Strategic Experimentation, Moral hazard, Adverse selection, Outsourcing, Integration and Separation.

JEL Classification: D83, D86