Capacity Constraints in Principal-Agent Problems

TL;DR

This paper shows that introducing capacity constraints in principal-agent problems effectively scales down the output, maintaining Pareto optimality, with the scaling factor increasing as the agent's effort capacity grows.

Contribution

It establishes a novel equivalence between constrained and unconstrained principal-agent problems through output scaling based on effort capacity.

Findings

Capacity constraints lead to output scaling in principal-agent problems.

The scaling factor increases with the agent's effort capacity.

Pareto optimal contracts remain unchanged under capacity constraints.

Abstract

Adding a capacity constraint to a hidden-action principal-agent problem results in the same set of Pareto optimal contracts as the unconstrained problem where output is scaled down by a constant factor. This scaling factor is increasing in the agent's capacity to exert effort.