MORAL HAZARD WITH COST AND REVENUE SIGNALS

Abstract

A risk neutral principal hires a risk averse agent to produce quality which is unobservable by the principal but generates a random stream of observable revenues. Unobservable effort and some other input called capital costs are perfect complements in the product at quality. The minimum level of capital costs required to produce a particular level of quality is random but provides a signal of agent effort. In particular agent effort serves to increase both expected capital costs and expected revenues. We assume that the principal offers a contract which specifies a set of linear revenue and capital cost shares and then examine how the correlation between capital costs and revenues determines whether the agent is rewarded or punished for incurring high capital costs.