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Dynamic Mechanism Design With Hidden Income and Hidden Actions

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  • Matthias Doepke

    (UCLA)

  • Robert M. Townsend

    (University of Chicago)

Abstract

We develop general recursive methods to solve for optimal contracts in dynamic principal-agent environments with hidden states and hidden actions. In our baseline model, the principal observes nothing other than transfers. Nevertheless, optimal incentive-constrained insurance can be attained. We show that the optimal contract can be implemented as a recursive direct mechanism with a vector of utility promises as the state variable. The standard recursive formulation suffers from a curse of dimensionality that arises from the interaction of hidden income and hidden actions; this curse can be overcome by introducing judiciously chosen utility bounds for deviation behaviour off the equilibrium path. Our methods generalize to environments with multiple actions and additional states. The key to implementing these extensions is to introduce multiple layers of off-path utility bounds.

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Bibliographic Info

Paper provided by UCLA Department of Economics in its series UCLA Economics Working Papers with number 818.

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Date of creation: 01 Apr 2002
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Handle: RePEc:cla:uclawp:818

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Web page: http://www.econ.ucla.edu/

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  2. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
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  10. Allen, Franklin, 1985. "Repeated principal-agent relationships with lending and borrowing," Economics Letters, Elsevier, vol. 17(1-2), pages 27-31.
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  14. Roger B. Myerson, 1977. "Incentive Compatability and the Bargaining Problem," Discussion Papers 284, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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  17. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, vol. 51(2), pages 367-390, August.
  18. Harris Milton & Townsend, Robert M, 1981. "Resource Allocation under Asymmetric Information," Econometrica, Econometric Society, vol. 49(1), pages 33-64, January.
  19. Myerson, Roger B., 1982. "Optimal coordination mechanisms in generalized principal-agent problems," Journal of Mathematical Economics, Elsevier, vol. 10(1), pages 67-81, June.
  20. Abreu, Dilip & Pearce, David & Stacchetti, Ennio, 1990. "Toward a Theory of Discounted Repeated Games with Imperfect Monitoring," Econometrica, Econometric Society, vol. 58(5), pages 1041-63, September.
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