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Information Processing: Contracts Versus Communication

We consider the trade-off between imperfect control and communication. A principal anticipates receiving private information and hires an agent to take an action. The principal can contractually tie the agent’s action to the state, but this control is incomplete. States not covered by a contract induce a communication game. We show that close alignment of interests favors communication and, thus, ceding authority to the agent, and vice versa. In the uniform-quadratic setting, optimal contracts use clauses to separate events that induce distinct communication actions. Hence, equilibria of the contract writing game are partitional and monotonic. The separation of distinct communication events relaxes incentive compatibility and, therefore, helps equalize the size of communication events. This highlights the dual role of contracting as both substituting for and facilitating communication – the principal uses contracts not only to impose her favorite actions, but also to structure communication. JEL: D83, D82