Dynamic Incentive Contracts under Parameter Uncertainty
AbstractWe analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's 'quality', the Pareto frontier shifts inwards with better information. Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8136.
Date of creation: Dec 2010
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Other versions of this item:
- Jovanovic, Boyan & Prat, Julien, 0. "Dynamic contracts when agent's quality is unknown," Theoretical Economics, Econometric Society.
- Prat, Julien & Jovanovic, Boyan, 2010. "Dynamic Incentive Contracts under Parameter Uncertainty," IZA Discussion Papers 5323, Institute for the Study of Labor (IZA).
- Julien Prat, 2011. "Dynamic Incentive Contracts Under Parameter Uncertainty," 2011 Meeting Papers 249, Society for Economic Dynamics.
- Julien Prat & Boyan Jovanovic, 2010. "Dynamic Incentive Contracts Under Parameter Uncertainty," NBER Working Papers 16649, National Bureau of Economic Research, Inc.
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
- E24 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution
- J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts
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