When writing contracts when actions are unobservable, what is the second step taken by the principal?
A) calculating the participation constraint
B) calculating the incentive compatibility constraint
C) calculating profits with different amounts of revenue and wages

Question

Quizplus · Accepted Answer

When actions are unobservable, the principal cannot directly contract on them. Therefore, the second step taken by the principal is to design the contract such that the agent has an incentive to reveal their true actions. This is achieved through calculating the incentive compatibility constraint, which specifies the optimal contract such that the agent has a higher payoff by truthfully revealing their actions. The participation constraint ensures that the agent's expected payoff from the contract is at least as high as their outside option. However, it is not the second step taken by the principal in this situation. The calculation of profits with different amounts of revenue and wages is useful but not directly relevant to designing a contract when actions are unobservable.

When Writing Contracts When Actions Are Unobservable, What Is the Second