Creating countervailing incentives through the choice of instruments

We analyze the relative efficiency of output and input incentive schemes in an agency model under adverse selection. Depending on the marginal rate of substitution between effort and productivity, two cases of note may appear. In the first one, both incentive schemes imply the same ranking of agents regarding the productivity parameter. In that case, one instrument always dominates the other one, whatever the agent's type. In the second case, the two schemes produce reverse rankings and the principal is always better off using a type-dependent mixed strategy over the two incentive schemes. If there is no restriction on mixed strategies, the principal is able to implement the first best. If the principal must use pure strategies, she is still better off by offering contracts with type-dependent monitoring instrument: allowing the agent to choose the instrument enhances the principal welfare. (C) 2000 Elsevier Science S.A. All rights reserved.