Limited Observability as a Constrint in Contract Design

Limited observability is the assumption that economic agents can only observe a finite amount of information. Given this constraint, contracts among agents are necessarily finite and incomplete in comparison to the ideal complete contract that we model as infinite in detail. We consider the extent to which finite contracts can approximate the idealized complete contracts. The objectives of the paper are: (i) to identify properties of agents’ preferences that determine whether or not finiteness of contracts causes significant inefficiency: (ii) to evaluate the performance of finite contracts against the ideal optimal contracts in principal−agent and bilateral bargaining models. Published: 2001 URL: http://www.business.uiuc.edu/Working_Papers/papers/01−0128.pdf Limited Observability as a Constraint in Contract Design∗ Stefan Krasa and Steven R. Williams Department of Economics University of Illinois 1206 South Sixth Street Champaign IL 61820 http://www.staff.uiuc.edu/ ̃skrasa [email protected]