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Dynamic Incentive Contracts Under Parameter Uncertainty

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  • Julien Prat

    (Institute of Economic Analysis (CSIC))

Abstract

We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent’s quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent’s “quality”, the Pareto frontier shifts inwards with better information. Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 249.

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Date of creation: 2011
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Handle: RePEc:red:sed011:249

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  1. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, Econometric Society, vol. 55(2), pages 303-28, March.
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Cited by:
  1. Keiichi Hori & Hiroshi Osano, 2013. "Managerial Incentives and the Role of Advisors in the Continuous-Time Agency Model," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 26(10), pages 2620-2647.
  2. Jianfeng Yu & Bin Wei & Zhiguo He, 2012. "Optimal Long-term Contracting with Learning," 2012 Meeting Papers, Society for Economic Dynamics 221, Society for Economic Dynamics.
  3. Giat, Yahel & Subramanian, Ajay, 2013. "Dynamic contracting under imperfect public information and asymmetric beliefs," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(12), pages 2833-2861.
  4. 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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