“When Are Robust Contracts Linear?” (joint with Daniel Walton)
Abstract:
We study a moral hazard situation in which a principal contracts with a counterparty, which may have its own internal organizational structure. The principal has non-Bayesian uncertainty as to what actions might be taken in response to the contract, and wishes to maximize her worst-case payoff. We show that if the possible responses to any given contract satisfy two axioms – a “richness” and a “responsiveness” axiom – then a linear contract is optimal. This general formulation encompasses not only direct contracting with an agent, but also various models of hierarchical contracting and contracting with teams of agents, showing that the arguments behind the robustness of linear contracts apply across a range of situations. We also further apply the modeling apparatus to compare the principal’s payoffs across different organizational structures.