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Moral hazard and persistence

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  • Hugo A. Hopenhayn
  • Arantxa Jarque

Abstract

We study a multiperiod principal-agent problem with moral hazard in which effort is persistent: the agent is required to exert effort only in the initial period of the contract, and this effort determines the conditional distribution of output in the following periods. We provide a characterization of the optimal dynamic compensation scheme. As in a static moral hazard problem, consumption ? regardless of time period ? is ranked according to likelihood ratios of output histories. As in most dynamic models with asymmetric information, the inverse of the marginal utility of consumption satisfies the martingale property derived in Rogerson (1985). Under the assumption of i.i.d. output we show that (i) incentives are concentrated in the later periods of the contract, implying an increase of the variance of compensation over time; (ii) the cost of implementing high effort decreases when there is an increase in either the duration or the intensity of persistence (i.e., how long and how strongly effort affects the distribution of output, respectively); and (iii) under infinite duration the cost gets arbitrarily close to that of the first best.

Suggested Citation

  • Hugo A. Hopenhayn & Arantxa Jarque, 2007. "Moral hazard and persistence," Working Paper 07-07, Federal Reserve Bank of Richmond.
    • Handle: RePEc:fip:fedrwp:07-07
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    References listed on IDEAS

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    Cited by:

    1. Wang, Cheng, 1997. "Incentives, CEO Compensation, and Shareholder Wealth in a Dynamic Agency Model," Journal of Economic Theory, Elsevier, vol. 76(1), pages 72-105, September.
    2. , & ,, 2014. "Dynamic contracts when agent's quality is unknown," Theoretical Economics, Econometric Society, vol. 9(3), September.
    3. Jacek Rothert, 2015. "Monitoring, moral hazard, and turnover," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 58(2), pages 355-374, February.

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    Keywords

    Microeconomics;

    JEL classification:

    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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