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Dynamic Contracting with Limited Commitment and the Ratchet Effect

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  • Dino Gerardi
  • Lucas Maestri

Abstract

We study dynamic contracting with adverse selection and limited commitment. A firm (the principal) and a worker (the agent) interact for potentially infinitely many periods. The worker is privately informed about his productivity and the firm can only commit to short-term contracts. The ratchet effect is in place since the firm has the incentive to change the terms of trade and offer more demanding contracts when it learns that the worker is highly productive. As the parties become arbitrarily patient, the equilibrium allocation takes one of two forms. If the prior probability of the worker being productive is low, the firm offers a pooling contract and no information is ever revealed. In contrast, if this prior probability is high, the firm fires the unproductive worker at the very beginning of the relationship.

Suggested Citation

  • Dino Gerardi & Lucas Maestri, 2015. "Dynamic Contracting with Limited Commitment and the Ratchet Effect," Carlo Alberto Notebooks 401, Collegio Carlo Alberto.
    • Handle: RePEc:cca:wpaper:401
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    References listed on IDEAS

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    Cited by:

    1. Mikhail Golosov & Luigi Iovino, 2021. "Social Insurance, Information Revelation, and Lack of Commitment," Journal of Political Economy, University of Chicago Press, vol. 129(9), pages 2629-2665.
    2. Alessandro Bonatti & Gonzalo Cisternas, 2020. "Consumer Scores and Price Discrimination," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 87(2), pages 750-791.
    3. Laura Doval & Vasiliki Skreta, 2022. "Mechanism Design With Limited Commitment," Econometrica, Econometric Society, vol. 90(4), pages 1463-1500, July.
    4. Doval, Laura & Skreta, Vasiliki, 0. "Optimal mechanism for the sale of a durable good," Theoretical Economics, Econometric Society.
    5. Beccuti, Juan & Möller, Marc, 2021. "Screening by mode of trade," Games and Economic Behavior, Elsevier, vol. 129(C), pages 400-420.
    6. Subir K. Chakrabarti & Jaesoo Kim, 2023. "Optimal equilibrium contracts in the infinite horizon with no commitment across periods," Theory and Decision, Springer, vol. 94(3), pages 379-404, April.
    7. Jeitschko, Thomas D. & Withers, John A., 2019. "Dynamic regulation revisited: Signal dampening, experimentation and the ratchet effect," DICE Discussion Papers 318, Heinrich Heine University Düsseldorf, Düsseldorf Institute for Competition Economics (DICE).
    8. Bhaskar, V. & Mailath, George J., 2019. "The curse of long horizons," Journal of Mathematical Economics, Elsevier, vol. 82(C), pages 74-89.
    9. Ambec, Stefan & Coria, Jessica, 2021. "The informational value of environmental taxes," Journal of Public Economics, Elsevier, vol. 199(C).
    10. Suehyun Kwon, 2019. "Revelation Principle with Persistent Correlated Types: Impossibility Result," CESifo Working Paper Series 7782, CESifo.
    11. Johannes Abeler & David Huffman & Collin Raymond & David B. Huffman, 2023. "Incentive Complexity, Bounded Rationality and Effort Provision," CESifo Working Paper Series 10541, CESifo.
    12. Suehyun Kwon, 2019. "Informed-Principal Problem in Mechanisms with Limited Commitment," CESifo Working Paper Series 7513, CESifo.
    13. Gao, Hong & Xu, Haibo, 2020. "Learning, belief manipulation and optimal relationship termination," Economics Letters, Elsevier, vol. 190(C).
    14. Martino Banchio & Frank Yang, 2021. "Dynamic Pricing with Limited Commitment," Papers 2102.07742, arXiv.org, revised Dec 2021.
    15. Abeler, Johannes & Huffman, David B. & Raymond, Collin, 2023. "Incentive Complexity, Bounded Rationality and Effort Provision," IZA Discussion Papers 16284, Institute of Labor Economics (IZA).
    16. S. Nageeb Ali & Navin Kartik & Andreas Kleiner, 2022. "Sequential Veto Bargaining with Incomplete Information," Papers 2202.02462, arXiv.org, revised Apr 2023.
    17. Brzustowski, Thomas & Georgiadis Harris, Alkis & Szentes, Balázs, 2023. "Smart contracts and the Coase conjecture," LSE Research Online Documents on Economics 117950, London School of Economics and Political Science, LSE Library.
    18. Breig, Zachary, 2022. "Repeated contracting without commitment," Journal of Economic Theory, Elsevier, vol. 204(C).

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    More about this item

    Keywords

    Dynamic Contracting; Limited Commitment; Ratchet Effect.;
    All these keywords.

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • 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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