Preference representation and randomization in principal-agent contracts

Conditions on an agent's preferences that induce a demand for ex ante randomization are derived. When the agent has constant absolute risk aversion in wealth but additive-separable preferences in wealth and effort, optimal contracts often require randomization. Under additive separability, the principal can use randomization to exploit the interaction between incentive considerations and the agent's outside opportunities. However, when the agent has constant absolute risk aversion in wealth but multiplicative-separable preferences, participation and incentive considerations separate; hence, optimal contracts do not exhibit ex ante randomization.