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Robust Incentive Contracts

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  • Wernerfelt, Birger

Abstract

We look at a principal-agent model in which the agent has to perform an action, the difficulty of which is better known ex interim than ex ante. We compare two contracting regimes; one with commitment to an ex ante negotiated contract, and one with an ex interim negotiated contract. The ex ante contract can not be too steep, but attempts to negotiate a steeper ex interim contract may result in bargaining failure. We find that the relative efficiency of the two contracting regimes depends on the nature of the differences between tasks. In a dynamic version of the analysis, we further find that the comparison depends on the frequency with which new tasks are needed. The argument can be interpreted as an analysis of the tradeoff between weak incentives in the firm and the possibility of unsuccessful negotiations in the market

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File URL: http://hdl.handle.net/1721.1/4052
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Bibliographic Info

Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 4448-03.

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Date of creation: 13 Feb 2004
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Handle: RePEc:mit:sloanp:4052

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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
Phone: 617-253-2659
Web page: http://mitsloan.mit.edu/
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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

Related research

Keywords: Theory of the Firm; Employment; Adjustments; Adaptation;

References

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  1. Drew Fudenberg & Bengt Holmstrom & Paul Milgrom, 1987. "Short-Term Contracts and Long-Term Agency Relationships," Working papers 468, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-28, March.
  3. Holmstrom, Bengt & Milgrom, Paul, 1994. "The Firm as an Incentive System," American Economic Review, American Economic Association, vol. 84(4), pages 972-91, September.
  4. Myerson, Roger B. & Satterthwaite, Mark A., 1983. "Efficient mechanisms for bilateral trading," Journal of Economic Theory, Elsevier, vol. 29(2), pages 265-281, April.
  5. Birger Wernerfelt, 2002. "Why Should the Boss Own the Assets?," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 11(3), pages 473-485, 09.
  6. Bajari, Patrick & Tadelis, Steven, 2001. "Incentives versus Transaction Costs: A Theory of Procurement Contracts," RAND Journal of Economics, The RAND Corporation, vol. 32(3), pages 387-407, Autumn.
  7. Steven Tadelis, 2002. "Complexity, Flexibility, and the Make-or-Buy Decision," American Economic Review, American Economic Association, vol. 92(2), pages 433-437, May.
  8. Jonathan Levin, 2003. "Relational Incentive Contracts," American Economic Review, American Economic Association, vol. 93(3), pages 835-857, June.
  9. Duncan Simester & Marc Knez, 2002. "Direct and Indirect Bargaining Costs and the Scope of the Firm," The Journal of Business, University of Chicago Press, vol. 75(2), pages 283-304, April.
  10. Wernerfelt, Birger, 1997. "On the Nature and Scope of the Firm: An Adjustment-Cost Theory," The Journal of Business, University of Chicago Press, vol. 70(4), pages 489-514, October.
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