Theoretical Economics, Volume 13, Number 3 (September 2018)

Theoretical Economics 13 (2018), 1425–1481

A general solution method for moral hazard problems

Rongzhu Ke, Christopher Thomas Ryan


Principal-agent models are pervasive in theoretical and applied economics, but their analysis has largely been limited to the ``first-order approach'' (FOA) where incentive compatibility is replaced by a first-order condition. This paper presents a new approach to solving a wide class of principal-agent problems that satisfy the monotone likelihood ratio property but may fail to meet the requirements of the FOA. Our approach solves the problem via tackling a max-min-max formulation over agent actions, alternate best responses by the agent, and contracts.

Keywords: Principal agent, moral hazard, solution method

JEL classification: D82, D86

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