In practice, incentive schemes are rarely tailored to the specific characteristics of contracting parties. However, according to economic theory, optimal contracts should be highly dependent on individual conditions. We reconcile these observations in the context of a principal-agent model with both moral hazard and adverse selection. Motivating an agent could be increasingly costly to the principal because a more productive agent could also be more able to manipulate the terms of the contract. As a result, the principal may optimally pool some types by offering a contract with constant transfer and bonus. We also explore parameterizations where the optimal contract is fully separating but simple contracts attain a significant portion of the optimal welfare.
JEL classiffication numbers: D86, L51, L22.
Keywords: Adverse Selection, moral hazard, Regulation, simple contracts.