This paper provides a new explanation for the dominance of the low-powered incentivecontract over the high-powered incentive contract using a mixed model of moral hazard andadverse selection. We first show that the power of incentives in the second-best contract islower than that in the first-best contract in the presence of either unobservable risk aversionor cost. We then consider the case that both risk aversion and cost of the agent are unob-servable to the principal. We solve this multidimensional mechanism design problem undertwo assumptions with regard to the structures of performance measurement system and wagecontract. It is shown that if the deterministic and stochastic components of different per-formance measures vary proportionally, the principal is inclined to provide a low-poweredincentive contract. Moreover, it is shown that if the base wage depends only on a quadraticfunction rather than the direction of the performance wage vector, no incentive is providedfor most of the performance measures in an orthogonal performance measurement system.
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