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Outside opportunities and termination

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  • Wang, Cheng
  • Yang, Youzhi

Abstract

We study a dynamic principal–agent relationship where a stochastic outside opportunity (offer) arises each period for the risk averse agent. Termination is costly, but it allows the agent to pursue the available outside opportunity and the principal to return to an external market to hire a new agent. The principal acts strategically with respect to the agent's outside offers and we show that it is optimal to terminate the current relationship if and only if the agent's outside offer is above a cutoff level. The optimal contract generates both voluntary and involuntary terminations. Severance compensation arises endogenously and we show that it may be paid only in involuntary terminations. Conditional on termination, the size of the optimal severance compensation depends positively on the agent's current compensation, but negatively on his outside offer. The optimal contract dictates an inverted-U relationship between compensation and the probability of termination.

Suggested Citation

  • Wang, Cheng & Yang, Youzhi, 2015. "Outside opportunities and termination," Games and Economic Behavior, Elsevier, vol. 91(C), pages 207-228.
    • Handle: RePEc:eee:gamebe:v:91:y:2015:i:c:p:207-228
    DOI: 10.1016/j.geb.2015.03.001
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    Cited by:

    1. Wang, Cheng, 2011. "Termination of dynamic contracts in an equilibrium labor market model," Journal of Economic Theory, Elsevier, vol. 146(1), pages 74-110, January.
    2. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    3. Wang, Cheng & Yang, Youzhi, 2019. "Optimal self-enforcement and termination," Journal of Economic Dynamics and Control, Elsevier, vol. 101(C), pages 161-186.
    4. Cheng Wang & Youzhi Yang, 2023. "On the Pure Theory of Wage Dispersion," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 47, pages 246-277, January.
    5. Wang, Cheng & Yang, Youzhi, 2022. "Optimal CEO turnover," Journal of Economic Theory, Elsevier, vol. 203(C).
    6. Luo, Jie & Wang, Cheng, 2018. "Optimal sovereign lending and default," Journal of International Economics, Elsevier, vol. 111(C), pages 190-213.

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    More about this item

    Keywords

    Optimal contracting; Outside opportunities; Termination; Severance compensation;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J63 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Turnover; Vacancies; Layoffs

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