A Note on the Dynamics of Incentive Contracts
AbstractLaffont and Tirole (1988) show that when the uncertainty about the agent's ability is small, the equilibrium must involve a large amount of pooling, but whether the continuation equilibrium induced by a optimal first-period menu of contracts is partition or not remains unclear. They construct a nonpartition continuation equilibrium for a given first-period menu of contracts and conjecture that this continuation equilibrium need not be suboptimal for the whole game under small uncertainty. We show that, irrespective of the amount of uncertainty, this nonpartition continuation equilibrium generates a strictly smaller payoff for the principal than a different menu of contracts with a partition continuation equilibrium. In this sense, Laffont and Tirole's menu of contracts, giving rise to a nonpartition continuation equilibrium, is not optimal. An intuition behind this result is provided that may shed some light on the problem of dynamic contracting without commitment.
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Bibliographic InfoPaper provided by Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance in its series Economics Series with number 2008_23.
Length: 16 pages
Date of creation: 13 Nov 2008
Date of revision:
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Incentive Contracts; Dynamic Contracting; Commitment; Partition Equilib-rium; Ratchet Effect; Bunching;
Other versions of this item:
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
- L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
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