Jeffrey S Banks, Rangarajan K Sundaram
ABSTRACT
This paper studies the interaction between a single long-lived principal
and a series of short-lived agents in the presence of both moral hazard
and adverse selection. We assume that the principal can influence the agents'
behavior only through her choice of a retention rule; this rule is further
required to be sequentially rational (i.e., no precommitment is allowed).
We provide general conditions under which equilibria exist in which (a)
the principal adopts a 'cut-off' rule under which agents are retained only
when the reward they generate exceeds a critical bound; and (b) agent separate
according to type, with better agents taking superior actions. We show
that in equilibrium, a retained agent's productivity is necessarily declining
over time, but that retained agents are also more productive on average
than untried agents due to selection effects. Finally, we show that for
each given type, agents of that type are more productive in the presence
of adverse selection than when there is pure moral hazard (i.e., when that
type is the sole type of agent in the model); nonetheless, adding uncertainty
about agent-types cannot benefit the principal except in uninteresting
cases.
Subject: Economic Theory, Principal/Agent Models (Theoretical)
Banks: (650) 321 2052 bnka@casbs.stanford.edu
& bnks@hss.caltech.edu
Sundaram: (212) 998-0308 rsundara@stern.nyu.edu
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