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Moral Hazard with Heterogeneous Beliefs

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  • Martin Dumav
  • Urmee Khan
  • Luca Rigotti

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.

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  • Martin Dumav & Urmee Khan & Luca Rigotti, 2021. "Moral Hazard with Heterogeneous Beliefs," Papers 2110.04368, arXiv.org.
    • Handle: RePEc:arx:papers:2110.04368
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    References listed on IDEAS

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    1. Simon Gervais & J. B. Heaton & Terrance Odean, 2011. "Overconfidence, Compensation Contracts, and Capital Budgeting," Journal of Finance, American Finance Association, vol. 66(5), pages 1735-1777, October.
    2. Gervais, Simon & Odean, Terrance, 2001. "Learning to be Overconfident," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 1-27.
    3. de la Rosa, Leonidas Enrique, 2011. "Overconfidence and moral hazard," Games and Economic Behavior, Elsevier, vol. 73(2), pages 429-451.
    4. Lopomo, Giuseppe & Rigotti, Luca & Shannon, Chris, 2011. "Knightian uncertainty and moral hazard," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1148-1172, May.
    5. Urmee Khan & Martin Dumav, 2018. "Moral Hazard, Uncertain Technologies, and Linear Contracts," Working Papers 201806, University of California at Riverside, Department of Economics.
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