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Robust Incentives

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  • Reich, S.

Abstract

In this paper we consider a moral hazard problem, in which the agent after receiving his wage contract but before undertaking the costly effort can borrow on his future wage earnings. The game between the agent and potential lenders is modelled as an in.nite stochastic game with an exogenous stopping probability. We show that the principal cannot design a wage scheme that is robust to hedging by the agent. In particular, we show that, if the exogenous stopping probability is non zero, the principal's wage offer will be followed by several rounds of borrowing by the agent. This is compared to the recontracting-proofness equilibria which most of the literature has concentrated on, assuming that this stopping probability is zero. Furthermore, we show that the equilibrium of the model with a strictly positive stopping probability does not converge to the equilibrium of the model in which it is zero. We also find that the principal.s profit is lower, the maximum wage payment can be higher and effort is lower.

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  • Reich, S., 2007. "Robust Incentives," Cambridge Working Papers in Economics 0729, Faculty of Economics, University of Cambridge.
  • Handle: RePEc:cam:camdae:0729
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    1. Alberto Bisin & Danilo Guaitoli, 2004. "Moral Hazard and Nonexclusive Contracts," RAND Journal of Economics, The RAND Corporation, vol. 35(2), pages 306-328, Summer.
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    3. Alberto Bisin & Piero Gottardi & Adriano A. Rampini, 2008. "Managerial Hedging and Portfolio Monitoring," Journal of the European Economic Association, MIT Press, vol. 6(1), pages 158-209, March.
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    5. Charles M. Kahn & Dilip Mookherjee, 1998. "Competition and Incentives with Nonexclusive Contracts," RAND Journal of Economics, The RAND Corporation, vol. 29(3), pages 443-465, Autumn.
    6. Peters, Michael, 2001. "Common Agency and the Revelation Principle," Econometrica, Econometric Society, vol. 69(5), pages 1349-1372, September.
    7. Bizer, David S. & DeMarzo, Peter M., 1999. "Optimal Incentive Contracts When Agents Can Save, Borrow, and Default," Journal of Financial Intermediation, Elsevier, vol. 8(4), pages 241-269, October.
    8. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January.
    9. Eli Ofek & David Yermack, 2000. "Taking Stock: Equity-Based Compensation and the Evolution of Managerial Ownership," Journal of Finance, American Finance Association, vol. 55(3), pages 1367-1384, June.
    10. Christine A. Parlour & Uday Rajan, 2001. "Competition in Loan Contracts," American Economic Review, American Economic Association, vol. 91(5), pages 1311-1328, December.
    11. Epstein, Larry G. & Peters, Michael, 1999. "A Revelation Principle for Competing Mechanisms," Journal of Economic Theory, Elsevier, vol. 88(1), pages 119-160, September.
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