MORAL HAZARD AND CONTRACTIBILITY IN INVESTMENT DECISIONS

This paper uses a principal-agent framework to study the incentive eff ects of contractibility and moral hazard at the first stage of a two-s tage investment decision. We show that when the intermediate signal is publicly observable and contractible, there is overinvestment (relati ve to the first-best) in second-stage production, purely for incentive reasons. However, if the intermediate signal cannot be contracted on and, in addition, the agent and the principal are permitted to act opp ortunistically, the optimal delegated investment decision is to underi nvest. We discuss the implications of our analysis for the literature on costly monitoring.