The Impact of Truth-Telling and Limited Wealth in a Principal-Agent Model

We derive the optimal contract in a model in which the agent's effort is unobservable and his findings are private information. Our focus is on the impact of the agent's wealth constraint. We show that three regions need to be distinguished: if the agent's wealth is above a critical threshold, then the principal implements a first-best effort without rent. In an intermediate wealth region, the principal implements a suboptimally low effort, but does not pay a rent. In the low wealth region, the effort is independent of the agent's wealth and the principal pays a rent. Surprisingly, the principal's profit does not necessarily increase with the percentage of good projects, and the equilibrium effort does not necessarily decrease with the percentage of good projects