Optimal Contracts Under Moral Hazard and Adverse Selection: A Continuous-Time Approach

51 Pages Posted: 5 Jul 2001

Date Written: June 21, 2001

Abstract

In spite of the importance of optimal contracting problems under moral hazard and adverse selection, current literature offers no optimal solutions to contracting problems under moral hazard and adverse selection with risk averse agents. The agent's risk aversion, however, appears to be critical for understanding managerial compensation problems. We present a continuous-time agency model with a risk-averse agent and a risk-neutral principal to show that moral hazard and adverse selection can be optimally resolved with a menu of linear contracts. In application, we discuss a few managerial compensation problems involving managerial project selection and capital budgeting decisions, and show that a flat-wage contract is sometimes optimal.

JEL Classification: C61, C73, D82, G31, L14

Suggested Citation

Sung, Jaeyoung, Optimal Contracts Under Moral Hazard and Adverse Selection: A Continuous-Time Approach (June 21, 2001). EFA 2001 Barcelona Meetings, Available at SSRN: https://ssrn.com/abstract=274543 or http://dx.doi.org/10.2139/ssrn.274543

Jaeyoung Sung (Contact Author)

Ajou University ( email )

Woncheon-dong, Yeongtong-gu
Suwon-si, Gyeonggi-do
Korea, Republic of (South Korea)

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