Optimal Technology Design

33 Pages Posted: 10 Dec 2020

See all articles by Daniel Ferguson Garrett

Daniel Ferguson Garrett

University of Toulouse 1 - Toulouse School of Economics (TSE)

George Georgiadis

Northwestern University - Kellogg School of Management

Alex Smolin

University of Toulouse 1 - Toulouse School of Economics (TSE)

Balazs Szentes

London School of Economics & Political Science (LSE) - Department of Economics

Date Written: October 2020

Abstract

This paper considers a moral hazard model with (i) a risk-neutral agent and (ii) agent limited liability. Prior to interacting with the principal, the agent designs the production technology, which is a specification of the agent's cost of generating each output distribution with support contained in [0,1]. After observing the production technology, the principal offers a payment scheme and then the agent chooses a distribution over outputs. First, we show that there is an optimal design involving only binary distributions on {0,1}; that is, the cost of any other distribution is prohibitively high. Then, we characterize the equilibrium technology defined on the binary distributions and show that the equilibrium payoff of both the principal and the agent is 1/e. A notable feature of the equilibrium is that the principal is indifferent between offering the equilibrium bonus rewarding output one and anything less than that. Finally, the analysis of the model is shown to generalize to the case where the agent is risk averse.

Keywords: moral hazard, limited liability, contract theory

JEL Classification: D82, D86

Suggested Citation

Garrett, Daniel Ferguson and Georgiadis, George and Smolin, Alex and Szentes, Balazs, Optimal Technology Design (October 2020). Available at SSRN: https://ssrn.com/abstract=3720594 or http://dx.doi.org/10.2139/ssrn.3720594

Daniel Ferguson Garrett

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

George Georgiadis (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Alex Smolin

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Balazs Szentes

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

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