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Dynamic costs and moral hazard: A duality-based approach

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  • Arie, Guy

Abstract

The marginal cost of effort often increases as effort is exerted. In a dynamic moral hazard setting, dynamically increasing costs create information asymmetry. This paper characterizes the optimal contract and helps explain the popular yet thus far puzzling use of non-linear incentives, for example, in sales-force compensation. The result is obtained by complementing the standard dynamic program with a novel dynamic dual formulation. The dual program is monotonic and sub-modular, providing stronger results, including a proof for the sufficiency of one-shot deviations.

Suggested Citation

  • Arie, Guy, 2016. "Dynamic costs and moral hazard: A duality-based approach," Journal of Economic Theory, Elsevier, vol. 166(C), pages 1-50.
  • Handle: RePEc:eee:jetheo:v:166:y:2016:i:c:p:1-50
    DOI: 10.1016/j.jet.2016.08.002
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    References listed on IDEAS

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    1. J. Gabriel & Raquiel López-Martínez & Onésimo Hernández-Lerma, 2001. "The lagrange approach to infinite linear programs," TOP: An Official Journal of the Spanish Society of Statistics and Operations Research, Springer;Sociedad de Estadística e Investigación Operativa, vol. 9(2), pages 293-314, December.
    2. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
    3. Albert Marcet & Ramon Marimon, 1994. "Recursive contracts," Economics Working Papers 337, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 1998.
    4. Bhaskar, Venkataraman, 2014. "The Ratchet Effect Re-examined: A Learning Perspective," CEPR Discussion Papers 9956, C.E.P.R. Discussion Papers.
    5. Gian Luca Clementi & Hugo A. Hopenhayn, 2006. "A Theory of Financing Constraints and Firm Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 121(1), pages 229-265.
    6. Noah Williams, 2011. "Persistent Private Information," Econometrica, Econometric Society, vol. 79(4), pages 1233-1275, July.
    7. Ramon Marimon, 2011. "New Results in Recursive Contract Theory," 2011 Meeting Papers 752, Society for Economic Dynamics.
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    More about this item

    Keywords

    Dynamic moral hazard; Nonlinear incentives; Private information; Dynamic mechanism design; Duality;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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