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Dynamic contracting with persistent shocks

  • Zhang, Yuzhe

In this paper, we develop continuous-time methods for solving dynamic principal-agent problems in which the agent's privately observed productivity shocks are persistent over time. We characterize the optimal contract as the solution to a system of ordinary differential equations and show that, under this contract, the agent's utility converges to its lower bound--immiserization occurs. Unlike under risk-neutrality, the wedge between the marginal rate of transformation and a low-productivity agent's marginal rate of substitution between consumption and leisure will not vanish permanently at her first high-productivity report; also, the wedge increases with the duration of a low-productivity report. We apply the methods to numerically solve the Mirrleesian dynamic taxation model, and find that the wedge is significantly larger than that in the independently and identically distributed (i.i.d.) shock case.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 144 (2009)
Issue (Month): 2 (March)
Pages: 635-675

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Handle: RePEc:eee:jetheo:v:144:y:2009:i:2:p:635-675
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

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  15. Yuzhe Zhang, 2005. "Dynamic contracting, persistent shocks and optimal taxation," Working Papers 640, Federal Reserve Bank of Minneapolis.
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