On Incentives, Temptation and Self-Control

We consider a principal-agent model, where a single agent exhibits problems of self control modelled using Gul, Pesendorfer (2001) type temptation preferences. For a general class of preferences, yet specific family of temptation utilities, we characterize an optimal contract in such a setting using standard Grossman, Hart (1983) techniques. Firstly, our analysis shows that contrary to standard results for the separable utility the first best solution may provide a variable pay. Secondly, in the second best the incentive compatibility constraint is not ecessarily binding. Both results from the fact that in our setting principal trade-offs incentives and insurance but also reduction of self control costs for the agent. Our new results shed some light on the justification of randomized contracts (see Holmstrom 1979), the literature on behavioral contracts, but also show that in the presence of strong self-control costs both first and second best coincide, and moral hazard cost is mitigated