Disentangling Moral Hazard and Adverse Selection
We analyze a canonical principal-agent problem with both moral hazard and adverse selection. We derive sufficient conditions for a menu of contracts to be feasible. We then provide a method of solution, which we call decoupling. It consists of first minimizing the cost of implementing any given action at any given surplus for any given type in a pure moral hazard problem, and then use the resulting cost function as an input to a pure adverse-selection problem. We show broad classes of primitives under which the solution to this radically simplified program is indeed optimal in the full problem. Decoupling has powerful implications for the structure of optimal menus. We illustrate our results in the context of an insurance market.
Jeroen Swinkels, Hector Chade
Swinkels, Jeroen, and Hector Chade. 2019. Disentangling Moral Hazard and Adverse Selection.