Moral hazard severity and contract design

In an agency setting where the agent must be compensated both to exert effort to produce a new project and to announce honestly when the new project has been produced, we show that Holmström's (1979) well-known "informativeness criterion" does not, by itself, determine whether a variable is optimally incorporated into the agent's contract. What also matters is how "severe" the control problem is between the principal and the agent. We further show that the severity of the moral hazard problem also determines whether it is desirable for the principal to have the agent implement the project more often than warranted by first-best implementation considerations. copyright