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Unobservable Persistent Productivity and Long Term Contracts

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Author Info
Hugo Hopenhayn (UCLA)
Arantxa Jarque (Universidad Carlos III de Madrid)

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Abstract

We study the problem of a firm that faces asymmetric information about the persistent productivity of its potential workers. In our framework, a worker's productivity is either assigned by nature at birth, or determined by an unobservable initial action of the worker that has persistent effects over time. We provide a characterization of the optimal dynamic compensation scheme that attracts only high productivity workers: consumption -- regardless of time period -- is ranked according to likelihood ratios of output histories, and the inverse of the marginal utility of consumption satisfies the martingale property derived in Rogerson (1985). However, in the case of i.i.d. output and square root utility we show that, contrary to the features of the optimal contract for a repeated moral hazard problem, the level and the variance of consumption are negatively correlated, due to the influence of early luck into future compensation. Moreover, in this example long-term inequality is lower under persistent private information. (Copyright: Elsevier)

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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

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Related research
Keywords: Mechanism design; Moral hazard; Persistence;

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Find related papers by JEL classification:
D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information

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