Trust and Discretion in Agency Contracts

We extend the standard agency framework to allow for complex information, trustworthiness of the principal, and incomplete contracts and show that contractual incompleteness arises endogenously when there is enough complexity and trust. Several predictions of the standard model break down in our more general construction: trust plays a crucial role in the design of optimal contracts; not all the relevant, valuable information on the agent’s choice of action is incorporated in the equilibrium contract; and, even when inference is perfect, the principal may only be able to implement the low cost effort. We conclude that one main function of agency contracts is to protect the agent from possible opportunistic behavior of the principal. ∗ We thank Emre Ozdenoren and participants at the Summer School in Economic Theory ‘Contracts and Markets with Boundedly Rational Agents’ held in Venice, Italy, on July 2001 for insightful comments. †Department of Managerial Economics and Decision Sciences, Kellogg School of Management, Northwestern University, Evanston IL 60208. ‡ Harvard Business School, Boston MA 02163.