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Simple contracts with double-sided moral hazard and adverse selection

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  • Tan, Lihua
  • Yang, Zhaojun

Abstract

We examine a linear contract model involving a risk-neutral venture capitalist (VC) hiring a risk-averse manager to run a project. The project output is determined by the joint efforts of both parties, the manager’s private ability and a random shock. We explicitly derive a truth-telling menu of contracts, which explain that the incentives provided by VC increase with the manager’s ability, under the widely-recognized monotone hazard rate condition. The fixed compensation would be negative; thus, the manager provides a portion of the financial investment and shares risks with VC. VC’s contracts can not distinguish the types of managers in a range of low-ability managers, leading to a partially pooling equilibrium. Conversely, within a range of high-ability managers, VC’s contracts identify the types of managers, resulting in convex information rents that increase with abilities. We explicitly provide ability thresholds specifying partially or completely pooling and separating equilibrium.

Suggested Citation

  • Tan, Lihua & Yang, Zhaojun, 2024. "Simple contracts with double-sided moral hazard and adverse selection," Economics Letters, Elsevier, vol. 236(C).
    • Handle: RePEc:eee:ecolet:v:236:y:2024:i:c:s0165176524000843
    DOI: 10.1016/j.econlet.2024.111601
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    References listed on IDEAS

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    1. Rafael Repullo & Javier Suarez, 2004. "Venture Capital Finance: A Security Design Approach," Review of Finance, European Finance Association, vol. 8(1), pages 75-108.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Optimal contracting; Venture capital; Double-sided moral hazard; Adverse selection; Screening game;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • M13 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - New Firms; Startups

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