In recent years it has become clear that the paradigm of a competitive market with large numbers of buyers and sellers determining price in a full information environment is not a very useful perspective for the study of a broad range of interesting economic relationships, such as the relationship between the shareholders of a firm and its managers, or between Congress, the military, and defense contractors. In these and many other relationships information about important economic variables is privately held and the response of economic actors in these relationships is to construct contractual relationships which give incentives for correct actions given the informational constraints of the situation. Thus shareholders must attempt to structure contracts which give managers the incentive to choose the right mix of projects for the firm as well as to exert sufficient effort in implementing them. The project contributes to four important unresolved issues in the study of contracts under asymmetric information. The first part develops a new method for determining when necessary conditions for optimal contracts can be derived from a first-order approach. The second topic involves the double-tiered agency problem, i.e., the principal offers a contract to his agent who in turn offers a contract to another agent. For example, society (the chief principal) gives the shareholders of the firm (the subordinate principal) a liability rule for accidents. The firm in turn hires directors and managers (the agent) who exert effort to reduce the probability that the product will be defective. Preliminary work suggests welfare gains if society directly imposes legal liability on managers. This will be the first time that this important problem has been studied within a contract theory framework. The third topic investigates the nature of optimal contracts when a better-informed agent must be given incentives to truthfully reveal his information to the principal. Finally the fourth topic concerns a number of approaches to modeling the contracting relationships in defense contracting among Congress, the military, and defense contractors.
