Learning from Failures: Optimal Contract for Experimentation and Production

55 Pages Posted: 3 Sep 2018

See all articles by Fahad Khalil

Fahad Khalil

University of Washington - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Jacques P. Lawarree

University of Washington - Department of Economics

Alexander Rodivilov

Stevens Institute of Technology - School of Business

Date Written: August 17, 2018

Abstract

Before embarking on a project, a principal must often rely on an agent to learn about its profitability. We model this learning as a two-armed bandit problem and highlight the interaction between learning (experimentation) and production. We derive the optimal contract for both experimentation and production when the agent has private information about his efficiency in experimentation. This private information in the experimentation stage generates asymmetric information in the production stage even though there was no disagreement about the profitability of the project at the outset. The degree of asymmetric information is endogenously determined by the length of the experimentation stage. An optimal contract uses the length of experimentation, the production scale, and the timing of payments to screen the agents. Due to the presence of an optimal production decision after experimentation, we find over-experimentation to be optimal. The asymmetric information generated during experimentation makes over-production optimal. An efficient type is rewarded early since he is more likely to succeed in experimenting, while an inefficient type is rewarded at the very end of the experimentation stage. This result is robust to the introduction of ex post moral hazard.

Keywords: Information Gathering, Optimal Contracts, Strategic Experimentation

JEL Classification: D82, D83, D86

Suggested Citation

Khalil, Fahad and Lawarree, Jacques P. and Rodivilov, Alexander, Learning from Failures: Optimal Contract for Experimentation and Production (August 17, 2018). Stevens Institute of Technology School of Business Research Paper, Available at SSRN: https://ssrn.com/abstract=3234143 or http://dx.doi.org/10.2139/ssrn.3234143

Fahad Khalil (Contact Author)

University of Washington - Department of Economics ( email )

Box 353330
Seattle, WA 98195-3330
United States

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Jacques P. Lawarree

University of Washington - Department of Economics ( email )

Box 353330
Seattle, WA 98195-3330
United States

Alexander Rodivilov

Stevens Institute of Technology - School of Business ( email )

Hoboken, NJ 07030
United States
2066077479 (Phone)

HOME PAGE: http://rodivilov.weebly.com/

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