Samuel C. A. Pereira
This paper explores a model in which the agent’s effort affects (solely) the precision (variance) of a performance measure (signal) of the outcome. Both the principal and the agent are risk averse. The contract the principal offers is composed of a fixed payment plus variable compensation, depending on the outcome and based on a (linear) risk-sharing rule between the principal and the agent. Moral hazard alone leads to an upward distortion (above the first-best) of the risk-sharing rule. This serves to induce more effort to increase information precision. Adverse selection alone introduces two new features. First, to reduce informational rents, the risk-sharing rule is distorted downward below the first-best. Second, to induce truthful information revelation, the risk-sharing rule becomes increasing with the expected outcome—the agent’s private information. When moral hazard and adverse selection are considered together, and there is enough uncertainty related to adverse selection, the risk-sharing rule is above the first-best for more efficient types, but below the first-best for less efficient types. Further, the precision of the signal increases with the expected outcome.