Non-monotone Incentives in a Model of Coexisting Hidden Action and Hidden Information

In this paper I consider a model of coexisting moral hazard and adverse selection, similar to one considered by Guesnerie, Picard, and Rey (1989). I provide an explicit solution for the optimal incentive scheme in the case, when the effort is observed with a normally distributed error. The main observation is that in this case the optimal incentive scheme often fails to be monotone. If the monotonicity constraint is imposed on the solution for economic reasons there would exist a region of profit realizations, such that the optimal compensation will be independent of on performance.