Risk aversion, ambiguity aversion and the incentive problem with interim participation constraints

• Author: Xinping Xia,Hongxia Wang,Jianli Wang
• Published date: 01 December 2019
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/ijet.12172

doi: 10.1111/ijet.12172

Risk aversion, ambiguity aversion and the incentive problem

with interim participation constraints

Hongxia Wang,∗Jianli Wang†and Xinping Xia‡

This work focuses on the effect of the principal’s aversion toward both risk and ambiguity on

the design of incentive contracts with interim participation constraints. We investigate how the

second-best outputs are affected by the strength of the principal’s risk aversion and ambiguity

aversion, respectively. Our result implies that the principal with more risk aversion is ready to

delegate a bigger production quantity to the inefficient agent. Wealso show how the principal’s

aversion toambiguit y affects the productionquantit y allocated tothe inefficient agent and clar ify

whether ambiguity aversion reinforces the effect of risk aversion.

Key wor ds interim participation constraint, risk aversion, ambiguity aversion

JEL classification D81, D82, D86

Accepted 4 September 2017

1 Introduction

When a principal delegates a task to an agent who has private information (e.g. the agent’s intrinsic

ability or the precise technology used), asymmetric information creates adverse selection. In order to

achieve an efficient use of economic resources, an optimal incentivecontract which elicits the agent’s

private information needs to be designed. This optimal contract is generally called the “second-best

contract,”which means that the principal must g ive up some information rent to the agent.

The previous literature demonstrates that risk aversion may affect the design of the optimal

incentive contract. For example, Lewis and Sappington (1995) analyze the optimal design of capital

structure in agency relationships and examine the impact of the principal’s risk aversion;Laffont and

Rochet (1998) extend Laffont and Tirole’s (1986) regulation model to the case of the risk-averse firm

and show that the agent’s risk aversion makes the principal weaken the incentive by adopting the

constant-absolute-risk-aversion (CARA) utility function. We refer to Laffont and Martimort (2002,

chapter 2) for further discussions.

Laffont and Martimort (2002, p. 52) show that the optimal contract with the interim participa-

tion constraint cannot implement the first-best outcome; instead, the second-best outcomeis imple-

mented. This implies that there is a output distortion from the first-best outcome for the inefficient

agent, thus the principal gives up some positive information rent to the efficient agent. Moreover,

∗College of Economics and Management, Nanjing Forestry University, Nanjing, China.

†College of Economics and Management, Nanjing University of Aeronautics and Astronautics, Nanjing, China. Email:

jianliwang@nuaa.edu.cn

‡School of Management, Huazhong Universityof Science and Technology, Wuhan,China.

Weare grateful to Jingyuan Li, a referee, and the editor for their valuable comments. This work is supported by National

Natural Science Foundation of China grants 71401074 and 71231005, and the Fundamental Research Funds for the

Central Universities under ResearchProject No. NR2016012.

International Journal of Economic Theory (2018) 1–14 © IAET 1

International Journal of Economic Theory

International Journal of Economic Theory 15 (2019) 327–340 © IAET 327