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Optimal Long-Term Contracting with Learning

Author

Listed:
  • Feng Gao
  • Zhiguo He
  • Bin Wei
  • Jianfeng Yu

Abstract

We introduce uncertainty into Holmstrom and Milgrom (1987) to study optimal long-term contracting with learning. In a dynamic relationship, the agent's shirking not only reduces current performance but also increases the agent's information rent due to the persistent belief manipulation effect. We characterize the optimal contract using the dynamic programming technique in which information rent is the unique state variable. In the optimal contract, the optimal effort is front-loaded and decreases stochastically over time. Furthermore, the optimal contract exhibits an option-like feature in that incentives increase after good performance. Implications about managerial incentives and asset management compensations are discussed.

Suggested Citation

  • Feng Gao & Zhiguo He & Bin Wei & Jianfeng Yu, 2016. "Optimal Long-Term Contracting with Learning," FRB Atlanta Working Paper 2016-10, Federal Reserve Bank of Atlanta.
    • Handle: RePEc:fip:fedawp:2016-10
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    More about this item

    Keywords

    executive compensation; moral hazard; Bayesian learning; hidden information; belief manipulation; private savings; continuous time; stock options;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • M12 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - Personnel Management; Executives; Executive Compensation

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