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Robust Incentives

  • Reich, S.
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    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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    File URL: http://www.econ.cam.ac.uk/research/repec/cam/pdf/cwpe0729.pdf
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    Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0729.

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    Length: 29
    Date of creation: May 2007
    Date of revision:
    Handle: RePEc:cam:camdae:0729
    Note: Ec
    Contact details of provider: Web page: http://www.econ.cam.ac.uk/index.htm

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    1. Christine A. Parlour & Uday Rajan, 2001. "Competition in Loan Contracts," American Economic Review, American Economic Association, vol. 91(5), pages 1311-1328, December.
    2. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 41-61, February.
    3. 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.
    4. Grossman, Sanford J & Hart, Oliver, 1985. "The Cost and Benefits of Ownership: A Theory of Vertical and Lateral Integration," CEPR Discussion Papers 70, C.E.P.R. Discussion Papers.
    5. Michael Peters, 1999. "Common Agency and the Revelation Principle," Working Papers peters-99-01, University of Toronto, Department of Economics.
    6. Sanford Grossman & Oliver Hart, . "An Analysis of the Principal-Agent Problem," Rodney L. White Center for Financial Research Working Papers 15-80, Wharton School Rodney L. White Center for Financial Research.
    7. Bisin, Alberto & Guaitoli, Danilo, 1998. "Moral Hazard and Non-Exclusive Contracts," CEPR Discussion Papers 1987, C.E.P.R. Discussion Papers.
    8. Piero Gottardi & Alberto Bisin & Adriano Rampini, 2007. "Managerial Hedging and Portfolio Monitoring," Working Papers 2007_24, Department of Economics, University of Venice "Ca' Foscari".
    9. 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.
    10. 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, 06.
    11. Larry Epstein & Michael Peters, 1996. "A Revelation Principle For Competing Mechanisms," Working Papers peters-96-02, University of Toronto, Department of Economics.
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