First-Order Approach to Principal-Agent Problems: A Generalization

The first-order approach (FOA) to principal agent problems is very convenient and mathematically tractable. However, existing results show that the FOA is valid only for additively separable utility functions. This is somewhat limiting. In this article sufficient conditions are identified that extend the validity of the FOA to nonseparable cases. The additional conditions involve restrictions on the agent's preferences, particularly interactions between action and the wage contract. These conditions imply that leisure is normal and the agent's absolute risk aversion increases with action. Comparative static results regarding the wage contract and its gradient are also discussed. The Geneva Papers on Risk and Insurance Theory (1997) 22, 59–65. doi:10.1023/A:1008663531322