Incentive contract

Authored Mateusz Szaryk

Abstract

Incentive contracts are agreements between two parties in which one party provides incentives for the other to undertake a certain action. These contracts are used in various settings, including employment, procurement, and government regulation, and are motivated by the desire to align the interests of the contracting parties and encourage the party receiving the incentives to behave in a manner that benefits both parties. The use of incentives in contracts has been shown to lead to improved performance and increased efficiency. For example, firms that use incentive-based compensation for their employees have higher productivity and better financial results than those that do not. In procurement, the use of incentives in contracts leads to improved product quality and reduced costs.

However, designing incentive contracts can be challenging. If the incentives are not well-designed, they can have unintended consequences and actually lead to suboptimal outcomes. The design of incentive contracts requires careful consideration of the incentives offered, the performance metrics used to evaluate the party receiving the incentives, and the potential for moral hazard. Incentive contracts can also pose challenges in implementation, such as measuring performance and mitigating moral hazard. Despite these challenges, incentive contracts have become an increasingly popular tool for improving performance and encouraging cooperation in a variety of settings. For example, in the employment setting, incentive-based compensation has become more common, as firms seek to align the interests of their employees with those of the firm. In procurement, incentive contracts have been used to encourage suppliers to improve product quality and reduce costs. In government regulation, incentive contracts have been used to encourage firms to adopt environmentally friendly practices.

Draft of Bibliography (Will grow)

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Laffont, Jean-Jacques, and David Martimort. "The Theory of Incentives: The Principal-Agent Model." Princeton University Press, 2002.