Moral Hazard and Sorting in a Market for Partnerships Ay¸ ca Kaya ∗ Galina Vereshchagina † University of Iowa Arizona State University October 2009 Abstract This paper incorporates two-sided moral hazard in an otherwise frictionless matching market for partnerships and examines how unobservability of the effort choices of the matched partners impacts the equilibrium sorting patterns. We find that the direction of this impact depends on whether unobservable effort and observable type are complements or substitutes: when they are complements (i.e.marginal products of effort are increasing in types), moral hazard favors negative sorting, and, conversely, when effort and type are substitutes, moral hazard favors positive sorting. Keywords: moral hazard, partnerships, assortative matching JEL Classification Numbers: D82, L23 1 Introduction Economic situations in which different agents form bilateral partnerships in order to engage in a productive activity are widespread (examples include business partnerships, co-authorship, mergers, etc). When the potential partners are heterogenous in their abilities, the question arises as to what kind of matches are formed in which economic environments. Understanding the impact of various features of the economic environment on how agents are sorted into partnerships is important for empirical as well as policy analysis. It is well known that, in the absence of any frictions, sorting outcomes are determined by the properties of the production technology: when it is strictly supermodular (strictly submodular) in the partners’ types, positive (negative) assortative matching obtains in all equilibria. 1 In this paper, we study how this link between the production technology and sorting patterns is impacted in the ∗ Contact: ayca-kaya@uiowa.edu † Contact: galinav@asu.edu 1 This result is due to Becker (1973). 1