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Hidden Action or Hidden Information? How Information Gathering Shapes Contract Design

A risk averse agent gathers information on productivity shocks and produces accordingly on behalf of his principal. Information gathering is imperfect so that the agent has either complete or no knowledge at all of those shocks. The model allows for moral hazard in information gathering, private information on productivity shocks and moral hazard on operating effort. Two polar scenarios of the agency literature with either pure hidden action (the agent exerts operating effort not knowing yet the realization of the shock) or pure hidden information (the agent knows that shock when exerting operating effort) arise endogenously with positive probability. An optimal menu of linear contracts mixes high-powered, productivity-dependent screening options following “good news” with a fixed low-powered option that solves a pure moral hazard problem otherwise.