What Is an Incentive-Compatible Contract

A mechanism is compatible with incentives if it encourages economic operators to honestly disclose private information. Consider introducing an income tax regime. The private information of an individual worker is the level of qualification or productivity in the job. Public information is the observed income of the individual, which is the product of skills and the number of hours worked. The optimal allocation for the economy is defined by a level of income and consumption for each skill level. An income tax system is compatible with incentives if it encourages each person to earn the income the government wants for their skill level. By earning the required income, each individual implicitly reveals the level of unobservable skills. The compatibility of incentives is imposed as a condition that any incentive contract must fulfil. From: Incentive Compatible Contract in A Dictionary of Finance and Banking » A contract designed to ensure mutually beneficial behavior of the parties. For example, the employment contracts of a company`s managers could include a bonus system to ensure that their interests and those of the shareholders are congruent. See the Agency number. A mechanism is called incentive-compatible (CI) when each participant can achieve the best result for themselves simply by acting according to their true preferences.

[1]: 225 [2] Search: “Incentive-compatible contract” in Oxford Reference”. . There are varying degrees of incentive compatibility:[3]. Typical examples of DSIC mechanisms are majority decisions between two alternatives and second-price auctions. A randomized mechanism is a probability distribution on deterministic mechanisms. There are two ways to define the incentive compatibility of randomized mechanisms:[1]: 231–232 Each DSIC mechanism is also BNIC, but a BNIC mechanism may exist even if no DSIC mechanism exists. The principle of disclosure exists in two variants, which correspond to the two flavors of incentive compatibility:. .

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