MORAL HAZARD AND TEMPORAL RESOLUTION OF UNCERTAINTY INCONTRACT THEORY

Moral hazard and temporal resolution of uncertainty are both well explored topics in behavioral economics. However a combination of both theories in principal-agent contracts is not yet available. Combining these theories in principal-agent contracts leads to a better understanding of the optimal wages in multi-period contracts with resolution of uncertainty. In this paper Kreps’ model of moral hazard (1990) and Kreps’ and Porteus’ model of temporal resolution of uncertainty (1978) are combined. Introducing temporal resolution of uncertainty in the moral hazard model leads to the same wages when probability and function changes are accounted for, but only when the uncertainty is resolved from the start. If this is not done, less optimal risk sharing will occur between principal and agent due to a more concave utility function of the agent. Therefore, the model creates a smaller share for the principal in principal-agent contracts. Due to the restrictive nature of Kreps’ moral hazard model, a generalization is made using Holmstrom’s (1979) moral hazard model, which gives the same results.