Providing Incentives with Private Contracts

Agents working together to produce a joint output care about each other’s incentives. Because real world contracts are typically private information, observed only by their direct signatories, agents are vulnerable to the principal opportunistically reducing the power of other agents’ incentives. When agents are sufficiently skilled, the principal can mitigate this commitment problem by making the most skilled one “team-leader,” with authority to write other agents’ contracts. This endogenous hierarchy, never optimal with public contracts, raises effort, output, and compensation, but distorts effort allocation due to rent extraction. Our model applies to bank syndicates, venture capital, organizational design, and outsourcing.