Microeconomics: Theory and Applications with Calculus, 4e

19.3 Trade-Off Between Efficiency in Production and in Risk Bearing

Writing an efficient contract is difficult if the agent knows more than the principal, the principal never learns the truth, and both face risk. Usually, a contract does not achieve efficiency in production and in risk bearing. Contract clauses that increase production efficiency may reduce efficiency in risk bearing, and vice versa. If these goals are incompatible, the parties may write imperfect contracts that compromise between the two objectives. To illustrate the trade-offs involved, we consider a common situation in which it is difficult to achieve efficiency: contracting with an expert such as a lawyer.

Pam, the principal, is injured in a traffic accident and is a plaintiff ...