Risk Sharing in an Adverse Selection Model

We introduce risk aversion in a mixed moral hazard/adverse selection model. Under plausible assumptions, the effort level of the firm is distorted downward from the first best level of effort for both agent types. Thus, the traditional result of no distortion on the top does not hold with risk aversion. We also show that the effort level of the low-cost type may be distorted more than that of the high cost type. With an observable cost shock, an increase in exogenous risk may increase the effort level of the efficient firm and lower the expected cost of the project.