Document Type

Discussion Paper

Publication Date

1-1-2014

CFDP Number

1935

CFDP Pages

42

Abstract

It is often suggested that incentive schemes under moral hazard can be gamed by an agent with superior knowledge of the environment, and that deliberate lack of transparency about the incentive scheme can reduce gaming. We formally investigate these arguments in a two-task moral hazard model in which the agent is privately informed about which task is less costly for him to work on. We examine two simple classes of incentive scheme that are “opaque” in that they make the agent uncertain ex ante about the values of the incentive coefficients in the linear payment rule. We show that, relative to deterministic menus of linear contracts, these opaque schemes induce more balanced efforts, but they also impose more risk on the agent per unit of aggregate effort induced. We identify settings in which optimally designed opaque schemes not only strictly dominate the best deterministic menu but also completely eliminate the efficiency losses from the agent’s better knowledge of the environment. Opaque schemes are more likely to be preferred to transparent ones when i) efforts on the tasks are highly complementary for the principal; ii) the agent’s privately known preference between the tasks is weak; iii) the agent’s risk aversion is significant; and iv) the errors in measuring performance on the tasks have large correlation or small variance.

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