Incentives under collusion in a two-agent hidden-action model of a financial enterprize

This study analyzes collusion in an enterprize in which concerns about hedging cannot be ignored. In our two-agent single-task hidden-action model, where all parties involved have exponential utility functions and the principal owning normally distributed observable and verifiable returns is restricted to offer linear contracts, agents are assumed to be able to exploit all feasible collusion opportunities via enforceable side contracts. Hence in general, an optimal incentive compatible and individually rational contract is not necessarily immune to collusion. We characterize situations in which concerns about collusion may or may not be ignored. Restrictions due to collusion are analyzed and we prove that collusion may be ignored when arranging the agents to work with the ``highest effort profile'' is optimal for the principal with the usual constraints, and the two moments of the return are monotone separately in effort levels of both of the agents. To show that these assumptions are minimal, we construct examples for situations in which any of these assumptions are violated, proving that collusion makes the principal strictly worse off.