Adverse selection with multiple inputs: mitigating information rents through input control

TL;DR: In a principal-agent relationship, inputs that could be chosen by either party are often controlled by the principal as mentioned in this paper, and the net effect of this tradeoff on social welfare depends primar- ily on the elasticity of substitution between inputs.

Abstract: In a principal-agent relationship, inputs that could be chosen by either party are often controlled by the principal. In the presence of adverse selection, the principal's profits are always higher when she con- trols an input than when she does not. Output is higher when she controls the input, since the second-best input specification reduces information rents. However, this mitigation distorts input use away from the production cost-minimizing level, which is socially costly. The net effect of this tradeoff on social welfare depends primar- ily on the elasticity of substitution between inputs: the restrictive contract results in higher social surplus than the basic contract if the elasticity of substitution between the inputs is sufficiently small. When the elasticity of substitution is large, the net effect is determined by secondary factors.