Ex-post moral hazard and manipulation-proof contracts

Abstract

We examine the trade-off between the provision of incentives to exert costly effort (ex-ante moral hazard) and the incentives needed to prevent the agent from manipulating the profit observed by the principal (ex-post moral hazard). Formally, we build a model of two-stage hidden actions where the agent can both influence the expected revenue of a business and manipulate its observed profit. We show that manipulation-proofness is sensitive to the interaction between the manipulation technology and the probability distribution of the stochastic output. The optimal contract is manipulation-proof whenever the manipulation technology is linear. However, a convex manipulation technology sometimes leads to contracts with manipulations in equilibrium. Whenever the distribution satisfies the monotone likelihood ratio property, we can always find a manipulation technology for which the optimal contract is not manipulation-proof.