Sharp and Diffuse Incentives in Contracting

This paper investigates the optimality of sharp incentives in contracts where output prices are set at the time of contracting but are random in nature. It shows that when prices are specified with error, schemes involv- ing sharp incentives might result in substantial deviations from first-best output levels. The randomness of prices creates arbitrage opportunities that are exploited by agents producing phenomena such as ’cost-shifting’. Both linear and piece-wise linear contracts are shown to be subject to the possibility of arbitrage. The paper then demonstrates that incentive schemes that are arbitrage-proof exhibit ‘diffuse’ incentives.