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Moral hazard and persistence

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  • Hugo 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.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 07-07.

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Date of creation: 2007
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Handle: RePEc:fip:fedrwp:07-07

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Keywords: Microeconomics;

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References

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  1. Sanford Grossman & Oliver Hart, . "An Analysis of the Principal-Agent Problem," Rodney L. White Center for Financial Research Working Papers 15-80, Wharton School Rodney L. White Center for Financial Research.
  2. MUKOYAMA, Toshihiko & SAHIN, Aysegül, 2004. "Repeated Moral Hazard with Persistence," Cahiers de recherche 01-2004, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  3. Arantxa Jarque, 2005. "Repeated Moral Hazard with Effort Persistence," 2005 Meeting Papers 428, Society for Economic Dynamics.
  4. Steven Shavell & Laurence Weiss, 1978. "The Optimal Payment of Unemployment Insurance Benefits over Time," Cowles Foundation Discussion Papers 503, Cowles Foundation for Research in Economics, Yale University.
  5. Hopenhayn, H. & Nicolini, P.J., 1996. "Optimal Unemployment Insurance," RCER Working Papers 421, University of Rochester - Center for Economic Research (RCER).
  6. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-89, July.
  7. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  8. Illoong Kwon, 2006. "Incentives, wages, and promotions: theory and evidence," RAND Journal of Economics, RAND Corporation, vol. 37(1), pages 100-120, 03.
  9. Borys Grochulski & Tomasz Piskorski, 2007. "Risky human capital and deferred capital income taxation," Working Paper 06-13, Federal Reserve Bank of Richmond.
  10. Rui Albuquerque & Hugo Hopenhayn, 2002. "Optimal Lending Contracts and Firm Dynamics," RCER Working Papers 493, University of Rochester - Center for Economic Research (RCER).
  11. Rogerson, William P, 1985. "Repeated Moral Hazard," Econometrica, Econometric Society, vol. 53(1), pages 69-76, January.
  12. 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.
  13. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  14. Kim, Son Ku, 1995. "Efficiency of an Information System in an Agency Model," Econometrica, Econometric Society, vol. 63(1), pages 89-102, January.
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Cited by:
  1. Jovanovic, Boyan & Prat, Julien, 0. "Dynamic contracts when agent'’s quality is unknown," Theoretical Economics, Econometric Society.
  2. Prat, Julien & Jovanovic, Boyan, 2010. "Dynamic Incentive Contracts under Parameter Uncertainty," IZA Discussion Papers 5323, Institute for the Study of Labor (IZA).
  3. Jacek Rothert, 2009. "Monitoring, Moral Hazard and Turnover," Department of Economics Working Papers 130124, The University of Texas at Austin, Department of Economics, revised Sep 2012.

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