Production externalities and two-way distortion in principal-multi-agent problems

This paper studies an otherwise standard principal-agent problem with hidde n information, but where there are positive production externalities betwee n agents: the output of any agent depends positively on the effort expended by other agents. It is shown that the optimal contract for the principal e xhibits two-way distortion: the effort of any agent is oversupplied (relati ve to the first-best) when his marginal cost of effort is low, and undersup plied taken his marginal cost of effort is high. This pattern of distortion cannot otherwise arise in optimal single- or multi-agent incentive contrac ts. unless there are countervailing incentives. However, unlike the counter vailing incentives case, the pattern of distortion we find is robust to the precise form of the externality. Journal of Economic Literature Classifica tion Numbers: D21, D28, (C) 2000 Academic Press.