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Tractability in Incentive Contracting

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  • Alex Edmans
  • Xavier Gabaix

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 sufficient 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. In a two-stage contracting game, the optimal target action depends on the costs and benefits of the environment, but is independent of the noise realization.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15545.

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Date of creation: Nov 2009
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Publication status: published as Alex Edmans & Xavier Gabaix, 2011. "Tractability in Incentive Contracting," Review of Financial Studies, Society for Financial Studies, vol. 24(9), pages 2865-2894.
Handle: RePEc:nbr:nberwo:15545

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Citations

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Cited by:
  1. Daniel F. Garrett & Alessandro Pavan, 2012. "Managerial Turnover in a Changing World," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 120(5), pages 879 - 925.
  2. Alex Edmans & Xavier Gabaix, 2010. "Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?," NBER Working Papers 15987, National Bureau of Economic Research, Inc.
  3. Marco LiCalzi & Alessandro Pavan, 2003. "Tilting the Supply Schedule to Enhance Competition in Uniform-Price Auctions," Working Papers, Fondazione Eni Enrico Mattei 2003.22, Fondazione Eni Enrico Mattei.
  4. Alex Edmans & Xavier Gabaix & Tomasz Sadzik & Yuliy Sannikov, 2009. "Dynamic Incentive Accounts," NBER Working Papers 15324, National Bureau of Economic Research, Inc.
  5. Chaigneau, Pierre, 2013. "Risk-shifting and the regulation of bank CEOs’ compensation," Journal of Financial Stability, Elsevier, Elsevier, vol. 9(4), pages 778-789.
  6. Laux, Volker, 2012. "Stock option vesting conditions, CEO turnover, and myopic investment," Journal of Financial Economics, Elsevier, Elsevier, vol. 106(3), pages 513-526.
  7. Golman, Russell & Bhatia, Sudeep, 2012. "Performance evaluation inflation and compression," Accounting, Organizations and Society, Elsevier, vol. 37(8), pages 534-543.
  8. George-Marios Angeletos & Alessandro Pavan, 2006. "Socially Optimal Coordination: Characterization and Policy Implications," NBER Working Papers 12778, National Bureau of Economic Research, Inc.
  9. Pierre Chaigneau & Nicolas Sahuguet, 2014. "Explaining the Association between Monitoring and Controversial CEO Pay Practices: an Optimal Contracting Perspective," Cahiers de recherche, CIRPEE 1406, CIRPEE.
  10. Edmans, Alex & Gabaix, Xavier, 2010. "Risk and CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?," Working Papers, University of Pennsylvania, Wharton School, Weiss Center 10-17, University of Pennsylvania, Wharton School, Weiss Center.
  11. Pierre Chaigneau & Nicolas Sahuguet, 2013. "The effect of monitoring on CEO pay practices in a matching equilibrium," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 55405, London School of Economics and Political Science, LSE Library.
  12. Zhiguo He & Si Li & Bin Wei & Jianfeng Yu, 2013. "Uncertainty, risk, and incentives: theory and evidence," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2013-18, Board of Governors of the Federal Reserve System (U.S.).

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