Ambiguity in Dynamic Contracts
AbstractI study a dynamic principal agent model in which the effort cost of the agent is unknown to the principal. The principal is ambiguity averse, and designs a contract which is robust to the worst case effort cost process. Ambiguity divides the contract into two regions. After sufficiently high performance, the agent reaches the over-compensation region, where he receives excessive benefits compared to the contract without ambiguity, while after low performance, he enters the under-compensation region. Ambiguity also causes a disconnect between the current effort cost and the strength of incentives. That is, even when the agent is under-compensated, his incentives are as strong as in the over-compensation region, since the principal fears the agent might shirk otherwise. Under ambiguity, the agent’s true effort cost does not need to equal the worst-case. I analyze the agent’s incentives for this case, and show that the possibility of firing is detrimental to the agent’s incentives. I study several extensions concerning the timing structure and the nature of the principal’s ambiguity aversion. JEL Code: D82, D86, M52
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Bibliographic InfoPaper provided by Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1543.
Date of creation: 16 Jan 2012
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Postal: Center for Mathematical Studies in Economics and Management Science, Northwestern University, 580 Jacobs Center, 2001 Sheridan Road, Evanston, IL 60208-2014
Web page: http://www.kellogg.northwestern.edu/research/math/
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Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
- M52 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-01-25 (All new papers)
- NEP-CTA-2012-01-25 (Contract Theory & Applications)
- NEP-MIC-2012-01-25 (Microeconomics)
- NEP-UPT-2012-01-25 (Utility Models & Prospect Theory)
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