Endogenous Selection and Moral Hazard in Executive Compensation Contracts

The two major paradigmsin the theoretical agency literature aremoral hazard (i.e., hidden action)and adverseselection (i.e., hiddeninformation). Prior research typically solves these problemsin isolation, as opposed to simultaneouslyincorporating both adverseselection and moral hazard features. We formulate two complementary generalized principal-agent models thatincorporate features observedin real world contracting environments (e.g., agents with power utilityand limited liability, lognormal stock price distributions,and stock options) as mathematical programs with equilibrium constraints (MPEC). We use state-of-the-art numerical algorithms to solve the resulting models. We find that many of the standard results no longer obtain when wealth effects are present. We also develop a new measure ofincentives calculated as the changein the agent's certainty equivalent under the optimal contract for a changein action evaluated at the optimal action. This measure facilitatesinterpretation of the resulting contractsand allows us to compare contracts across different contracting environments