Commitment Problem, Optimal Incentive Schemes, and Relational Contracts in Agency with Bilateral Moral Hazard

Abstract

In a bilateral moral hazard framework, where the principal is also a productive agent, therequirements of both the agent’s and the principal's incentive provisions should be satisfied in designing optimal incentive contracts. In a static framework, only the second best is obtainable if the incentive contract is based only on the total output. One example of this is the simple linear sharing rule that is often observed. Next, it is shown that in a repeated game version, such a commitment problem could be solved, and a first best outcome could be achieved through both parties taking trigger strategies that depend on a public signal. We give an interpretation in the viewpoint of the 'reputation' mechanism, and a qualitative characterization on the optimal solution induced in equilibrium for all possible discount factors. Finally, some applications for corporate governance are presented.