Rewarding Success and Failure : Moral Hazard and Adverse Selection in Strategic Experimentation

A principal hires an agent to learn about the cost of a project (experimentation) and then to execute it (production). The agent is privately informed about the probability that the cost is low, with the high-type agent being relatively more optimistic than the low type. The agent also engages in costly experimentation over time to uncover the true cost. Thus, there is both adverse selection and moral hazard. Moral hazard requires the principal to reward success in experimentation, but adverse selection may induce the principal to also reward failure in experimentation. We find that the relative probability of failure across the agent’s types monotonically increases over time allowing the principal to use the timing of failure as a screening instrument despite the presence of moral hazard. Therefore, both success and failure are rewarded with different payments and a specific timing in the optimal contract. We also consider whether it may be optimal to separate experimentation and production between two different agents. Having the same agent working on both tasks enables the principal to use the adverse selection rent to address moral hazard. If adverse selection is severe, yielding a large rent, the principal can satisfy the moral hazard constraints by spreading the adverse selection rent over the duration of experimentation. Therefore, integrating experimentation and production is optimal when adverse selection is severe