Probationary contracts in agencies with bilateral asymmetric information

This paper examines a two-period principal and agent model where the agent's ability level is not observable to the principal and revealed to the agent only after the contract is signed. The value of the agent's output to the principal is affected by the agent's collegiality, which is unknown to the agent, but is observed by the principal. In these circumstances, with risk-neutral agents, the principal prefers a "probationary scheme" with second-period rehiring based on satisfactory first-period performance. Multiple equilibria results from this problem. However, the refinements literature provides a resolution to the multiplicity. Under certain conditions, the agent is rehired for sufficiently high first-period output; the superior agent will work harder in the first period than under recontracting, and the inferior-type agent will work less hard. The probationary scheme is shown to be Pareto superior to standard recontracting.