PREFERENCE REPRESENTATION AND RANDOMIZATION IN PRINCIPAL-AGENT CONTRACTS

Conditions on an agent's preferences that induce a demand for ex ante randomization are derived. When the agent has constant absolute risk a version in wealth but additive-separable preferences in wealth and eff ort, optimal contracts often require randomization. Under additive sep arability, the principal can use randomization to exploit the interact ion between incentive considerations and the agent's outside opportuni ties. However, when the agent has constant absolute risk aversion in w ealth but multiplicative-separable preferences, participation and ince ntive considerations separate; hence, optimal contracts do not exhibit ex ante randomization.