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Tractability in Incentive Contracting

Author

Listed:
  • Edmans, Alex

    (University of PA)

  • Gabaix, Xavier

    (NYU)

Abstract

This 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 correct 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.

Suggested Citation

  • Edmans, Alex & Gabaix, Xavier, 2010. "Tractability in Incentive Contracting," Working Papers 10-13, University of Pennsylvania, Wharton School, Weiss Center.
    • Handle: RePEc:ecl:upafin:10-13
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    More about this item

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts

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