Asymmetric awareness and moral hazard

Abstract

This paper introduces asymmetric awareness into the classical principal–agent model and discusses the optimal contract between a fully aware principal and an unaware agent. The principal enlarges the agent's awareness strategically when proposing a contract and faces a tradeoff between participation and incentives. Leaving the agent unaware allows the principal to exploit the agent's incomplete understanding of the world, relaxing the participation constraint, while making the agent aware enables the principal to use the revealed contingencies as signals about the agent's action choice, relaxing the incentive constraint. The optimal contract reveals contingencies that have low probability but are highly informative about the agent's effort.