Sharp and Diffuse Incentives in Contracting

This paper investigates the optimality of sharp incentives in contracts where output prices are set at the time of contracting but are random in nature. It shows that when prices are specified with error, schemes involving sharp incentives might result in substantial deviations from first-best output levels. The randomness of prices creates arbitrage opportunities that are exploited by agents producing phenomena such as "cost-shifting". Both linear and piece-wise linear contracts are shown to be subject to the possibility of arbitrage. The paper then demonstrates that incentive schemes that are arbitrage-proof exhibit "diffuse" incentives.


Issue Date:
2007
Publication Type:
Working or Discussion Paper
Record Identifier:
http://ageconsearch.umn.edu/record/151183
PURL Identifier:
http://purl.umn.edu/151183
Total Pages:
16
JEL Codes:
D81; D86
Series Statement:
Risk and Uncertainty Program
R07/6




 Record created 2017-04-01, last modified 2018-01-22

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