TY - JOUR
T1 - Learning from failures
T2 - Optimal contracts for experimentation and production
AU - Khalil, Fahad
AU - Lawarree, Jacques
AU - Rodivilov, Alexander
N1 - Publisher Copyright:
© 2020 Elsevier Inc.
PY - 2020/11
Y1 - 2020/11
N2 - Before embarking on a project, a principal must often rely on an agent to learn about its profitability. We model this learning as a two-armed bandit problem and highlight the interaction between learning (experimentation) and production. We derive the optimal contract for both experimentation and production when the agent has private information about the efficiency of experimentation. This private information in the experimentation stage generates asymmetric information in the production stage even though there was no disagreement about the profitability of the project at the outset. The degree of asymmetric information is endogenously determined by the length of the experimentation stage. An optimal contract uses the length of experimentation, the production scale, and the timing of payments to screen the agent. We find that over-experimentation and over-production can be used to reduce the agent's rent. An efficient type is rewarded early since he is more likely to succeed in experimenting, while an inefficient type is rewarded at the very end of the experimentation stage. This result is robust to the introduction of ex post moral hazard.
AB - Before embarking on a project, a principal must often rely on an agent to learn about its profitability. We model this learning as a two-armed bandit problem and highlight the interaction between learning (experimentation) and production. We derive the optimal contract for both experimentation and production when the agent has private information about the efficiency of experimentation. This private information in the experimentation stage generates asymmetric information in the production stage even though there was no disagreement about the profitability of the project at the outset. The degree of asymmetric information is endogenously determined by the length of the experimentation stage. An optimal contract uses the length of experimentation, the production scale, and the timing of payments to screen the agent. We find that over-experimentation and over-production can be used to reduce the agent's rent. An efficient type is rewarded early since he is more likely to succeed in experimenting, while an inefficient type is rewarded at the very end of the experimentation stage. This result is robust to the introduction of ex post moral hazard.
KW - Information gathering
KW - Optimal contracts
KW - Strategic experimentation
UR - http://www.scopus.com/inward/record.url?scp=85090411441&partnerID=8YFLogxK
UR - http://www.scopus.com/inward/citedby.url?scp=85090411441&partnerID=8YFLogxK
U2 - 10.1016/j.jet.2020.105107
DO - 10.1016/j.jet.2020.105107
M3 - Article
AN - SCOPUS:85090411441
SN - 0022-0531
VL - 190
JO - Journal of Economic Theory
JF - Journal of Economic Theory
M1 - 105107
ER -