On the first-order approach in principal–agent models with hidden borrowing and lending

• DOI: 10.1016/j.jet.2011.03.002
• Publication Date: 2011-03-07T22:11:59Z
• Authors: Árpád Ábrahám; Sebastian Koehne; Nicola Pavoni
• Keywords: Moral hazard; Risk Aversion

We provide sufficient conditions for the validity of the first-order approach for two-period dynamic moral hazard problems where the agent can save and borrow secretly. The first-order approach is valid if the following conditions hold: (i) the agent has non-increasing absolute risk aversion utility (NIARA), (ii) the output technology has monotone likelihood ratios (MLR), and (iii) the distribution function of output is log-convex in effort (LCDF). Moreover, under these three conditions, the optimal contract is monotone in output. We also investigate a few possibilities of relaxing these requirements.