Principal-agent Theory And Information Reporting Mechanisms

In this paper, we study a principal-agent problem with hidden action and hidden information. The manager who is the agent in this problem has private information about, and control over, the mean and variance of his outputs; the manager's outputs consist of a sample of independently distributed cash flows, all having mean and variance determined by manager's action choices. The principal designs a contract that both elicits the manager's private information and directs the manager's actions.Joel S. Demski and Ronald A. Dye (1999) design a polynomial contract that is quadratic in the sample mean and variance. But their study show that the manager's report of his chosen project's mean understates the true mean of the project by an amount which increases in his risk aversion, the weight placed on the sample mean, and population variance of his chosen project. And it is impossible to have the manager's announced project variance.In this paper, we design a contract that is not a polynomial contract, but this contract can elicits the manager's true private information about the mean and variance of his outputs.