Incentive Feasible Contracts:

Incentive Compatibility and Participation

The  problem with  the  above contract scheme  is that it does not  satisfy  the incentive compatibility. Let us assume that the marginal cost  6  is the agent's private information,  and  the  principal  offers the  menu  of contracts ,  agents with  type θ,θ'. But  you  can  see  from Figure above that B*  is preferred to A*  by  both types of agents. Hence offering the menu  (A*, B*)  fails  to have the  agents self-selecting properly within this menu. The efficient  type agent will have an incentive  to mimic the inefficient one  and  will  select  the contract  B*.  The  result  is  complete information  optimal contracts can no  longer  be  implemented under asymmetric information.

In  order  to  be  incentive  compatible,  i.e.,  for agent  is  weakly preferred to  (t',q') and for agent    is weakly preferred  to  (t, q), we must have  

Thus, a menu of contracts  is incentive feasible if it satisfies  both incentive and participation constraints 

  The  inequalities (4.9) through  (4.12)  present the  set  of  incentive feasible menus of contracts. In the presence of asymmetric information between  the principal and the agent,  these additional constraints have to be imposed on the resource allocation.