Optimal Contract, Imperfect Output Observation and Limited Liability
Abstract We study the optimal contract when output is imperfectly observed. When all parties are risk neutral and the agent has unlimited liability, the optimal contract remains the same regardless of whether the output is perfectly or imperfectly observed. When the agent's liability becomes limited, the optimal contract changes profoundly under imperfect information. We show that the high-productivity agent never produces at first-best and may be required to produce an effort lower than the one required from the low-productivity agent, and both types of agents can earn rents. Journal of Economic Literature Classification Number: D82.