Imprecise Beliefs in a Principal Agent Model∗

This paper presents a principal-agent model where the agent has multiple, or imprecise, beliefs. We model this situation formally by assuming the agent’s preferences are incomplete. One can interpret this multiplicity as limited knowledge of the surrounding environment. In this setting, incentives need to be robust to the agent’s beliefs. We study whether robustness implies simplicity. Under mild conditions, we show the unique optimal contract has a two-wage structure. That is, all output levels are divided into two groups, and the optimal incentive scheme pays the same amount for all output levels in each group. When monotonicity occurs, this is a flat payment plus bonus contract. Then, a two-state two-action framework can be thought of as a reduced form of the original model. We solve explicitly the principal’s problem in this case, and discuss some implications of our model for firm ownership. JEL Codes: D82, D81, D23 ∗I thank Truman Bewley and Ben Polak for invaluable advice; Aldo Rustichini Dirk Bergemann, Subir Bose, Simon Grant, Georg Kirchsteiger, June K. Lee, David Pearce, Matthew Ryan, Chris Shannon, and Dolf Talman gave useful comments at various stages of this work; I also thank seminar audiences at Arizona State, CORE, Universitat Autonoma de Barcelona, ITAM, Stanford, Tilburg, and Yale. †E-mail: [email protected]