Optimal Contracting with Effort and Misreporting

We propose a new continuous time contracting model, where the project value process can only be observed with noise, and there are two sources of moral hazard: effort and misreporting. Using calculus of variation techniques, we are able to find the optimal pay-per-performance sensitivity (PPS) of the contract offered to the manager, as well as optimal effort and misreporting action via a second order ordinary differential equation with time dependent coefficients. Our findings indicate that the agent will apply a higher level of effort and misreporting than if only one of those actions was present.