<p>"Steep incentives schemes" are synonymous with "high-powered incentives". A steep incentive scheme is thus one in which there is a large or high-powered performance incentive. This can take either the form of a small fixed payment and a (potentially) large bonus, or it can be a large fixed payment and a (potentially) large penalty for deviation.</p>

<p>Normally we think about using steep incentive schemes when we wish to have a separating equilibrium in which high-skilled (or risk-seeking) workers choose steep incentive schemes and low-skilled (or risk-averse) workers choose flatter incentive schemes. Here is one paper I'm aware of that discusses this. You will find more examples if you look at optimal contracts under risk-aversion. <a href="https://www.econstor.eu/bitstream/10419/30169/1/620692227.pdf" rel="nofollow noreferrer">https://www.econstor.eu/bitstream/10419/30169/1/620692227.pdf</a></p>

<p>In your example, I believe the decreasing nature of <span class="math-container">$a(T)$</span> is capturing the movement from a low-cost (less risky) project to a high-cost (more risky) project. As the cost (risk) for the project increases, the principal will want a steep incentive scheme to ensure that only a high-skilled contractor will choose to perform the task. This is because we are shifting the weight away from <span class="math-container">$a(T)$</span> (the fixed payment) and towards <span class="math-container">$a'(T) \times (T-C)$</span> (the bonus/penalty) as <span class="math-container">$T$</span> increases. Moving the other direction, as the cost (risk) for the project decreases, <span class="math-container">$a(T)$</span> increases and the incentives have less power.</p>

CC BY-SA 4.0
2019-12-05T20:06:59.157Z
2019-12-05T20:06:59.157Z
corran_horn
<p>This term was mentioned in a slide and when I looked online, the only thing which I could find talking about this is <a href="http://faculty.haas.berkeley.edu/przemekj/skimming.pdf" rel="nofollow noreferrer">this paper</a>. </p>

<p>For example,in the cost-plus-incentive contract</p>

<p><span class="math-container">$$x(T, c) = a(T) - a'(T) × (T-c)$$</span></p>

<p>where <span class="math-container">$x$</span> is the contractor's fee, <span class="math-container">$T$</span> is the cost target, <span class="math-container">$c$</span> is a verifiable cost; <span class="math-container">$a(T)$</span> is decreasing and convex.</p>

<p>I was told that with smaller <span class="math-container">$T$</span> and hence higher <span class="math-container">$a(T)$</span> and <span class="math-container">$-a'(T)$</span>, the incentive contract is steeper. Is the steepness represented by <span class="math-container">$-a'(T)$</span>? What exactly is the interpretation of steepness of incentive contract? Does it mean more risk for the contractor? If this is the case, am I correct that the decreasing <span class="math-container">$a(T)$</span> motivates the contractor to take a smaller T? How is it translated to incentive constraint? That high-cost contractor would not recklessly take a small T?</p>

<game-theory><asymmetric-information><principal-agent>
What does "steep incentive contract" mean in the context of adverse selection?
Aqqqq
# What does "steep incentive contract" mean in the context of adverse selection?

(Asked by: username_0 on 2019-12-03)

This term was mentioned in a slide and when I looked online, the only thing which I could find talking about this is [this paper](http://faculty.haas.berkeley.edu/przemekj/skimming.pdf).

For example,in the cost-plus-incentive contract

$$x(T, c) = a(T) - a'(T) × (T-c)$$

where $x$ is the contractor's fee, $T$ is the cost target, $c$ is a verifiable cost; $a(T)$ is decreasing and convex.

I was told that with smaller $T$ and hence higher $a(T)$ and $-a'(T)$, the incentive contract is steeper. Is the steepness represented by $-a'(T)$? What exactly is the interpretation of steepness of incentive contract? Does it mean more risk for the contractor? If this is the case, am I correct that the decreasing $a(T)$ motivates the contractor to take a smaller T? How is it translated to incentive constraint? That high-cost contractor would not recklessly take a small T?

**Tags:** game-theory, asymmetric-information, principal-agent

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## 1 answers

### Answer by username_1 on 2019-12-05. Score: 1

"Steep incentives schemes" are synonymous with "high-powered incentives". A steep incentive scheme is thus one in which there is a large or high-powered performance incentive. This can take either the form of a small fixed payment and a (potentially) large bonus, or it can be a large fixed payment and a (potentially) large penalty for deviation.

Normally we think about using steep incentive schemes when we wish to have a separating equilibrium in which high-skilled (or risk-seeking) workers choose steep incentive schemes and low-skilled (or risk-averse) workers choose flatter incentive schemes. Here is one paper I'm aware of that discusses this. You will find more examples if you look at optimal contracts under risk-aversion. <https://www.econstor.eu/bitstream/10419/30169/1/620692227.pdf>

In your example, I believe the decreasing nature of $a(T)$ is capturing the movement from a low-cost (less risky) project to a high-cost (more risky) project. As the cost (risk) for the project increases, the principal will want a steep incentive scheme to ensure that only a high-skilled contractor will choose to perform the task. This is because we are shifting the weight away from $a(T)$ (the fixed payment) and towards $a'(T) \times (T-C)$ (the bonus/penalty) as $T$ increases. Moving the other direction, as the cost (risk) for the project decreases, $a(T)$ increases and the incentives have less power.


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