Tractability in Incentive Contracting
AbstractThis paper identifies a class of multiperiod agency problems in which the optimal contract is tractable (attainable in closed form). By modeling the noise before the action in each period, we force the contract to provide sufficient incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We thus extend the tractable contracts of Holmstrom and Milgrom (1987) to settings that do not require exponential utility, a pecuniary cost of effort, Gaussian noise or continuous time. The contract's functional form is independent of the noise distribution. Moreover, if the cost of effort is pecuniary (multiplicative), the contract is linear (log-linear) in output and its slope is independent of the noise distribution, utility function and reservation utility. In a two-stage contracting game, the optimal target action depends on the costs and benefits of the environment, but is independent of the noise realization.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7578.
Date of creation: Nov 2009
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- D2 - Microeconomics - - Production and Organizations
- D3 - Microeconomics - - Distribution
- G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
- J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-12-05 (All new papers)
- NEP-BEC-2009-12-05 (Business Economics)
- NEP-CTA-2009-12-05 (Contract Theory & Applications)
- NEP-UPT-2009-12-05 (Utility Models & Prospect Theory)
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