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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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File URL: http://hdl.handle.net/10.1093/rfs/hhr044
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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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  1. Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
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  16. Hui Ou-Yang, 2003. "Optimal Contracts in a Continuous-Time Delegated Portfolio Management Problem," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 173-208.
  17. Brian J. Hall & Jeffrey B. Liebman, 1997. "Are CEOs Really Paid Like Bureaucrats?," NBER Working Papers 6213, National Bureau of Economic Research, Inc.
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  19. Hall, Brian J. & Murphy, Kevin J., 2002. "Stock options for undiversified executives," Journal of Accounting and Economics, Elsevier, vol. 33(1), pages 3-42, February.
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  21. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April.
  22. Baker, George P, 1992. "Incentive Contracts and Performance Measurement," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 598-614, June.
  23. Yuliy Sannikov, 2008. "A Continuous-Time Version of the Principal-Agent Problem," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 957-984.
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  25. Maug, Ernst & Dittmann, Ingolf, 2007. "Lower Salaries and No Options: The Optimal Structure of Executive Pay," Sonderforschungsbereich 504 Publications 07-41, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
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