Aggregation and Linearity in the Provision of Intertemporal Incentives
AbstractOne of the main findings of the principal-agent literature has been that incentive schemes should be sensitive to all information that bears on the agent's actions. As a manifestation of this principle, incentive schemes tend to take quite complex (non-linear) forms. In contrast, real world schemes are often based on aggregate information with a rather simple structure. This paper considers the optimality of linear schemes that use only aggregated information. The hypothesis is that linear schemes are to be expected in situations where the agent has a rich set of actions to choose from, because richness in action choice allows the agent to circumvent highly nonlinear schemes. We show that optimal compensation schemes are indeed linear functions of appropriate accounting aggregates in a multi-period model where the agent can observe and respond to his own performance over time. Furthermore, when profits evolve according to a controlled Brownian motion (with the agent at the controls) the optimal compensation scheme is linear in profits. The optimal scheme can be computer as if the principal could only choose among linear rules in a corresponding static problem. Applications of this ad hoc principle appear quite promising and are briefly illustrated.
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Bibliographic InfoPaper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 742.
Length: 55 pages
Date of creation: Aug 1985
Date of revision:
Publication status: Published in Econometrica (March 1987), 55(2): 303-328
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA
Other versions of this item:
- Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-28, March.
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- Paul Milgrom & Robert Weber, 1981. "Distributional Strategies for Games with Incomplete Information," Discussion Papers 428R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Sanford Grossman & Oliver Hart, .
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Rodney L. White Center for Financial Research Working Papers
15-80, Wharton School Rodney L. White Center for Financial Research.
- Bengt Holmstrom, 1979.
"Moral Hazard and Observability,"
Bell Journal of Economics,
The RAND Corporation, vol. 10(1), pages 74-91, Spring.
- Steven Shavell, 1979. "Risk Sharing and Incentives in the Principal and Agent Relationship," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 55-73, Spring.
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