Moral Hazard with Heterogeneous Beliefs

TL;DR

This paper explores how moral hazard contracts are affected by differing beliefs between agents and principals, showing that belief heterogeneity influences contract structure and incentives.

Contribution

It introduces a model of moral hazard with heterogeneous beliefs, analyzing how belief differences impact optimal incentive contracts and wage schemes.

Findings

Increased belief disagreement leads to incentives moving in the direction of greater disagreement.

The shape of optimal wages is sensitive to differences in beliefs.

Beliefs heterogeneity can eliminate the typical risk-sharing and incentive trade-off.

Abstract

We study a model of moral hazard with heterogeneous beliefs where each of agent's actions gives rise to a pair of probability distributions over output levels, one representing the beliefs of the agent and the other those of the principal. The agent's relative optimism or pessimism dictates whether the contract is high-powered (i.e. with high variability between wage levels) or low-powered. When the agent is sufficiently more optimistic than the principal, the trade-off between risk-sharing and incentive provision may be eliminated. Using Monotone Likelihood Ratio ranking to model disagreement in the parties' beliefs, we show that incentives move in the direction of increasing disagreement. In general, the shape of the wage scheme is sensitive to the differences in beliefs. Thereby, key features of optimal incentive contracts under common beliefs do not readily generalize to the case of belief heterogeneity.