Motivating Informed Decisions
Abstract: This paper studies a principal-agent model where a risk-neutral principal delegates to a risk-neutral agent the decision of whether to pursue a risky project or a safe one. The return from the risky project is unknown and the agent can acquire costly unobservable information about it before taking the decision. The problem has features of moral hazard and hidden information since the acquisition of information and its content are unobservable to the principal. The optimal contract suggests that the principal should only reward the agent for outcomes that are significantly better than the safe return. It is also optimal to distort the project choice in favor of the risky one as a mechanism to induce the direct revelation of the uncertain state. In a managerial context, the findings explain why options and profit sharing compensation induce better decision making from CEOs, as well as why excessive risk taking might be optimal.
