| Abstract: | An agent undertakes a nonobservable first‐stage effort. The principal observes whether the effort results in a successful project or not. If the project succeeds, only the firm observes its interim quality, and can further improve it with a nonobservable second‐stage effort. If the agent accepts penalties when the first‐stage fails, moral hazard and asymmetric information do not prevent the principal from implementing her first‐best outcome. However, if the agent is bounded by the maximum loss he can bear when the first‐stage fails (limited liability), the principal induces the agent to exert a first‐stage effort below the first‐best level and a second‐stage effort above the first‐best level when the interim quality of his project is low. This distortion in efforts implies that the ex post rent left to the agent with a project of high interim quality is above the first‐best level. This provides a rationale for the optimality of expanding the use of the “carrot” (second‐stage rent) when the use of the “stick” (first‐stage penalty) is restricted. Implications of the theory for R&D, bank, job, and insurance contracts are discussed. |
