A Revelation Mechanism for Soft Information under Moral Hazard

• Published date: 01 October 2016
• Date: 01 October 2016
• Author: GUILLAUME ROGER
• DOI: http://doi.org/10.1111/jpet.12169

AREVELATION MECHANISM FOR SOFT INFORMATION UNDER

MORAL HAZARD

GUILLAUME ROGER

The University of Sydney

Abstract

This paper constructs a revelation mechanism to address a problem

of moral hazard under soft information. The agent alone observes the

stochastic outcome of her action, which she reports to the principal.

Therefore the principal also faces a problem of ex post adverse selection.

Economically relevant restrictions induce constraints on the principal’s

choice of mechanism and the Revelation Principle fails to apply. Specif-

ically, a direct mechanism induces some pooling, which does not repli-

cate the allocation obtained using a larger message space. Pooling also

weakens the ex ante incentives. The Revelation Principle is extended to

obtain type separation. A better audit relaxes frictions.

1. Introduction

Models of moral hazard rely on an informative signal of the agent’s action to condition

her compensation. However, performance may not be observed at all. For example, an

accounting report is not a direct observation of the state of a firm; it is a message about

the underlying state. This paper analyzes precisely this problem: the principal observes

neither the action, nor the outcome of that action, which must be elicited ex post.Many

real-life situations fit this description. A board typically asks of a CEO to report his (her)

results while on the job. A regulated firm may be asked to reveal its production costs

after investing in an uncertain technology.

I consider an agency model where only the agent observes the stochastic outcome of

her action. Then moral hazard and adverse selection interact: addressing moral hazard

requires a state-contingent transfer schedule, which creates incentives for information

manipulation. This has implications for the choice of a revelation mechanism. For any

information to be conveyed, the revelation mechanism must include an audit and a

penalty for misreporting. Imperfect audit and bounded penalties leave room to over-

state one’s true type.

This paper focuses on the construction of an adequate revelation mechanism. It

shows that using a direct mechanism constrains communication for at least some types,

who pool at the upper bound of the type space. This is problematic because it weakens

Guillaume Roger, School of Economics, The University of Sydney (guillaume.roger72@gmail.com).

I especially thank Guido Friebel, Mike Peters, Ralph Winter, John Wooders,as well as Bill Schworm,

Chris Bidner, Carlos Pimienta, Suraj Prasad, and Luis Vasconcelosfor helpful comments.

Received September 6, 2014; Accepted April 12, 2015.

C2016 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 18 (5), 2016, pp. 752–763.

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