Optimal Subjective Contracting with Revision

Abstract

We study the optimal contracting problem with subjective evaluation when the principal can ask the agent to revise his work. The possibility of revision benefits the principal by providing the option value of making another attempt at the work. However, it also introduces a new type of incentive problem for the principal: she may ask for revision even if it is inefficient to do so. This new incentive issue for the principal also affects the incentive of the agent: he may procrastinate his effort in anticipation of excessive revision. This results in a trilemma: The optimal contract cannot simultaneously provide for efficient revision, efficient effort, and minimal ex post surplus destruction. The optimal contract will of necessity contain at least one of the following problems: revision, the principal asks for excessive revision; procrastination, the agent shirks in the early stage; or punishment, excessive surplus destruction at low-quality final output. This paper was accepted by Joshua Gans, business strategy.