Contracting with private knowledge of signal quality


  • We are particularly grateful to the editor, David Martimort, and two anonymous referees for extremely insightful comments and suggestions. We also thank Sanford Berg, Roger Blair, Mark Jamison, and Ted Kury for their helpful assistance.


We characterize the optimal procurement contract in a setting where a supplier has privileged knowledge of the quality of a public signal about his production costs. The optimal contract exhibits important differences with standard contracts in adverse selection settings. For instance, the contract induces output both above and below first-best levels. Furthermore, the induced output may not vary with the realized public signal unless the signal quality is sufficiently pronounced. In addition, output may increase as expected costs increase.