Moral Hazard With Unawareness

Abstract

The article introduces unawareness of actions into the standard moral hazard model in contract theory. We allow the contracting party (the principal or the agent) to be unaware of his or the other party's actions. The principal may also have an incorrect belief about the awareness of the agent. We provide a solution concept where the principal contemplates the incentive scheme according to his conjecture of the agent's mind and also contemplates informing the agent through the contract. In the post-contractual stage, either party may be surprised by the other party's action. Finally, we analyze the value of awareness for each party, and present the negative result that awareness is not always valuable.

Keywords

moral hazard unawareness incomplete contracts rule-following bounded rationality

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