Who and How? Adverse Selection and flexible Moral Hazard

Abstract

We characterize incentive-compatible mechanisms in environments with hidden types and flexible hidden actions. Our approach introduces extended recommendation schedules that also prescribe actions off path, after misreports. This yields a tractable and complete characterization of incentive compatibility, which includes a generalized integral monotonicity condition capturing the interaction between adverse selection and moral hazard. We illustrate the usefulness of the characterization in a range of applications, including franchise agreements, employment contracts, and optimal taxation, covering both risk neutrality and risk aversion, with and without limited liability. Among other results, we identify a broad class of environments in which menus of affine contracts are optimal for a profit maximizing principal.