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Tractability in Incentive Contracting

  • Alex Edmans
  • Xavier Gabaix

This article develops a framework that delivers tractable (i.e., closed-form) optimal contracts, with few restrictions on the utility function, cost of effort, or noise distribution. By modeling the noise before the action in each period, we force the contract to provide correct 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 illustrate the potential usefulness of our setup by a series of examples related to CEO incentives. In particular, the model derives predictions for the optimal measure of incentives and whether the contract should be convex, concave, or linear. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 24 (2011)
Issue (Month): 9 ()
Pages: 2865-2894

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Handle: RePEc:oup:rfinst:v:24:y:2011:i:9:p:2865-2894
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