Moral Hazard with Hidden Information

Abstract

Moral hazard with hidden information refers to a control problem where the agent’s actions are observable, but not the information on which they are based. This paper analyses the case in which an agent (for example a subcontractor or a dealer) obtains perfect information before deciding on his action. The close relationship to adverse selection allows easy derivation of the set of feasible sharing rules. The optimal action (production plan) is then derived, and it is shown that action efficiency (and incentive power) is uniformly lower than first-best (except in the best and the worst state), but greater than efficiency in the corresponding adverse selection problem. It is shown that efficiency and incentive strength is decreasing uniformly in the agent’s aversion to risk (properly defined). The level of risk may be endogenously as well as exogenously determined. Holding exogenous risk constant it is shown that risk averse agents tend to end up with more risky production plans. However, the effects of exogenous changes in risk are ambiguous. It is further demonstrated that the risk aversion of the principal will have the opposite effect as a more risk averse principal will tend to prefer more efficient (and less risky) production. Finally, it is argued that principals prefer agents to be informed before actions are taken, but after contracting. This information structure also represents a social optimum.