“Moral Hazard and Observability”, 1979 (; backlinks; similar):
The role of imperfect information in a principal-agent relationship subject to moral hazard is considered. A necessary and sufficient condition for imperfect information to improve on contracts based on the payoff alone is derived, and a characterization of the optimal use of such information is given.
…Employing a different problem formulation from Harris and Raviv’s, we are able to simplify their analysis and generalize their results substantially. Both questions posed above are given complete answers (in our particular model).
It is shown that any additional information about the agent’s action, however imperfect, can be used to improve the welfare of both the principal and the agent. This result, which formalizes earlier references to the value of monitoring in agency relationships (1975; 1975), serves to explain the extensive use of imperfect information in contracting. Furthermore, we characterize optimal contracts based on such imperfect information in a way which yields considerable insight into the complex structure of actual contracts.
The formulation we use is an extension of that introduced by Mirrlees (197450ya, 1976). We start by presenting a slightly modified version of Mirrlees’ model (§2), along with some improved statements about the nature of optimal contracts when the payoff alone is observed. In §3 a detour is made to show how these results can be applied to prove the optimality of deductibles in accident insurance when moral hazard is present. §4 gives the characterization of the optimal use of imperfect information and §5 presents the result when imperfect information is valuable. Up to this point homogeneous beliefs are assumed, but in §6 this assumption is relaxed to the extent that we allow the agent to be more informed at the time he chooses his action. The analysis is brief, but indicates that qualitatively the same results obtain as for the case with homogeneous beliefs. §7 contains a summary and points out some directions for further research.
…When the payoff alone is observable, optimal contracts will be second-best owing to a problem of moral hazard. By creating additional information systems (as in cost accounting, for instance), or by using other available information about the agent’s action or the state of nature, contracts can generally be improved.
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