Contracting with Moral Hazard, Adverse Selection and Risk Neutrality : When Does One Size Fit All?

This paper studies a principal-agent model in which the principal and agent are risk-neutral, there are two actions, adverse selection, moral hazard and limited liability. When the two actions are subject to moral hazard, there is no distortion at the top, the optimal action profile is downward distorted for everyone else and the optimal menu of contract exhibits the one-size-fits-all property; that is, each ability type receives the same contract. The optimal contract pays a bonus when the outcome with the highest likelihood ratio is observed and the limited liability otherwise. When one of the actions is contractible and the other is subject to moral hazard, there is no distortion at the top, the non-contractible action is downward distorted for everyone else, the contractible action can be either upward or downward distorted. The optimal contract no longer exhibits the one-size-fits-all property. The one-size-fits-all property sheds light why we rarely observe menus of contracts in market that use franchising, credit and labor markets, and in regulated industries