Optimal Contracts with Costly Information Acquisition

This paper analyzes a dynamic moral-hazard model where a principal searches for an opportunity of uncertain return, and hires an agent to evaluate potential options that arrive stochastically over time. The agent’s effort affects the informativeness of a signal about an option’s return. Based on the information provided by the agent, the principal decides whether or not to exercise an option at hand. We derive properties of the optimal contract. We show that the agent is rewarded for delivering ‘bad news’ when the prior about the option return is low. This leads to an additional incentive problem when the agent can hide the presence of an option. We characterize distortions (relative to the first best) on the implemented effort level and the optimal stopping decision. We also study the dynamics induced by the optimal contract.