The Power of Information for Intermediate States in Contract Design

TL;DR

This paper introduces a new model in principal-agent problems that incorporates intermediate states, analyzing how contracts leveraging this information can outperform standard contracts under certain conditions.

Contribution

It proposes a novel framework with intermediate states and evaluates two new contract types that utilize this information, demonstrating their potential advantages.

Findings

Intermediate-state-aware contracts can outperform standard contracts.

The pay-halfway and terminate-halfway contracts leverage intermediate information.

Certain circumstances significantly favor intermediate-state-based contracts.

Abstract

In the conventional principal-agent problem, a principal delegates a task to an agent and formulates a contract to incentivize the agent's actions on behalf of the principal. However, this framework overlooks the information that is possibly available during the delegation process in some scenarios. To address this limitation, we propose a novel model that incorporates multiple intermediate states to capture such information revealed during the delegation. Furthermore, to evaluate the impact of the information embedded in these intermediate states, we introduce two distinct contracts: the pay-halfway contract, which provides payments based not only on final outcomes but also on intermediate states, and the terminate-halfway contract, which allows the principal to terminate the delegation process upon encountering undesirable intermediate states. This leads to the question of whether and how these contract types can leverage intermediate-state information? In particular, we ask: Can these contract types outperform standard contracts, and if so, when and to what extent? We answer the first question affirmatively and provide several important insights regarding the second, shedding light on the circumstances in which intermediate-state-aware contracts yield substantial advantages.