Endogenous Correlation and Moral Hazard

Abstract: We study a contracting problem in which the agent’s action is two-dimensional. First, the agent controls the marginal distribution of a performance signal. Second, the agent manipulates the correlation between this performance measure and some exogenous signal like the business cycle. The model allows us to revisit the Informativeness Principle, which originally assumes that the agent’s action is one-dimensional and the information structure fixed. In the latter model, the principal is better off the higher the exogenous correlation is between the two signals. However, in the model with endogenous correlation, the principal may be better off incentivizing the agent to lower the correlation between the two signals. The optimal contract then appears less sensitive to exogenous signals than suggested by the standard approach. We examine the difference in the structure of the optimal contract in the two models. Several other applications of the new model are pursued as well.