Contracting with private knowledge of signal quality

We characterize the optimal procurement contract in a setting where a supplier has privileged knowledge of the quality of a public signal about his production costs. The optimal contract exhibits important differences with standard contracts in adverse selection settings. For instance, the contract induces output both above and below first-best levels. Furthermore, the induced output may not vary with the realized public signal unless the signal quality is sufficiently pronounced. In addition, output may increase as expected costs increase. Copyright (c) 2010, RAND.