Measurement Distortion and Missing Contingencies in Optimal Contracts (Reprint 018)

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Abstract
Standard contract theory suggests that in optimal contract payments should be contingent on many events, but in practice this rarely happens. For example, financial securities typically do not make payments contingent on accounting information. This paper develops a theory to explain these missing contingencies. The first important element of the theory is that contracts are based on signals produced by measurement systems which are manipulable. The second is that the contracting parties have incomplete information about each other’s type. Given these two assumptions, it is shown that in equilibrium a non-competitive contract is optimal.
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