Contractual Structure and Endogenous Matching in Partnerships

We analyze optimal contracts and optimal matching patterns in a simple model of partnershipwhere there is a double-sided moral hazard problem and potential partners differ intheir productivity in two tasks. It is possible for one individual to accomplish both tasks (soleproduction) and there are no agency costs associated with this option but partnerships are abetter option if comparative advantages are significant. We show that the presence of moralhazard can reverse the optimal matching pattern relative to the first best, and that even ifpartnerships are optimal for an exogenously given pair of types, they may not be observed inequilibrium when matching is endogenous, suggesting that empirical studies on agency costsare likely to underestimate their extent by focusing on the intensive margin and ignoring theextensive margin.[...]