Strategic Information Transmission in the Employment Relationship

We incorporate private information and strategic communication (Crawford and Sobel, 1982) into Simon’s (1951) model of the employment relationship. We consider contracts between a principal and an agent that specify a bounded finite number of instructions and a fixed wage. Once the principal, privately, learns the state, she can either enforce one of the instructions from the contract or send a non-binding cheap- talk message to the agent. In the former case, the principal determines the action, in the latter case the agent does. All contracts partition the state space into ‘topics,’ with each topic giving rise to a game in its own right. With little conflict, optimal contracts specify approximately the maximal available number of instructions, and there will be at least one topic in which there is (cheap-talk) communication. For ‘extreme conflict’ optimal contracts are simple, specify a single instruction, and do not generate communication. In the uniform-quadratic specification, with sufficiently small conflict, topics from optimal contracts induce similar numbers of cheap-talk actions.