Optimally Coarse Contracts

Abstract

We study a principal-agent model in which actions are imperfectly contractible and the principal chooses the extent of contractibility at a cost. If contractibility costs satisfy a monotonicity property---which is implied by costs that come from difficulties in distinguishing actions when writing the contract---then optimal contracts are necessarily coarse: they specify finitely many actions out of a continuum of possibilities. This result holds even if contractibility costs are arbitrarily small. Applying our results to a nonlinear pricing model, we study how changes in consumer demand, production costs, and informational asymmetries affect the optimally coarse set of quality options.

Keywords: Mechanism Design, Incomplete Contracts, Principal-Agent Models, Nonlinear Pricing, Adverse Selection, Moral Hazard

JEL Classification: D82, D86