MIT

A central tenet of economics is that people respond to incentives. While an appropriately crafted incentive scheme can achieve the second-best optimum in the presence of moral hazard, the principal must be very well informed about the environment (e.g. the agent’s preferences and the production technology) in order to achieve this. Indeed it is often suggested that in-centive schemes can be gamed by an agent with superior knowledge of the environment, and furthermore that lack of transparency about the nature of the incentive scheme can reduce gam-ing. We provide a formal theory of these phenomena. We show that random or ambiguous incentive schemes induce more balanced efforts from an agent who performs multiple tasks and who is better informed about the environment than the principal is. On the other hand, such random schemes impose more risk on the agent per unit of effort induced. By identifying settings in which random schemes are especially effective in inducing balanced efforts, we show that, if tasks are sufficiently complementary for the principal, random incentive schemes can dominate the best deterministic scheme. (JEL L13, L22