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Dynamic Incentive Contracts under Parameter Uncertainty

  • Prat, Julien

    ()

    (CREST)

  • Jovanovic, Boyan

    ()

    (New York University)

We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's "quality", the Pareto frontier shifts inwards with better information. Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.

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Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 5323.

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Length: 49 pages
Date of creation: Nov 2010
Date of revision:
Publication status: forthcoming in: Theoretical Economics
Handle: RePEc:iza:izadps:dp5323
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  1. Manishi Prasad & Peter Wahlqvist & Rich Shikiar & Ya-Chen Tina Shih, 2004. "A," PharmacoEconomics, Springer Healthcare | Adis, vol. 22(4), pages 225-244.
  2. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
  3. Leena Rudanko, 2005. "Labor Market Dynamics under Long Term Wage Contracting," 2005 Meeting Papers 876, Society for Economic Dynamics.
  4. Jarque, Arantxa, 2010. "Repeated moral hazard with effort persistence," Journal of Economic Theory, Elsevier, vol. 145(6), pages 2412-2423, November.
  5. Marek Kapicka, 2013. "Efficient Allocations in Dynamic Private Information Economies with Persistent Shocks: A First-Order Approach," Review of Economic Studies, Oxford University Press, vol. 80(3), pages 1027-1054.
  6. Gibbons, R. & Murphy, K.J., 1990. "Optimal Incentive Contracts In The Presence Of Career Concerns: Theory And Evidence," Working papers 563, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Noah Williams, 2008. "Persistent Private Information," 2008 Meeting Papers 360, Society for Economic Dynamics.
  8. Mark Westerfield & Tobias Adrian, 2007. "Disagreement and Learning in a Dynamic Contracting Model," 2007 Meeting Papers 270, Society for Economic Dynamics.
  9. Noah Williams, 2004. "On Dynamic Principal-Agent Problems in Continuous Time," Levine's Bibliography 122247000000000426, UCLA Department of Economics.
  10. Rogerson, William P, 1985. "The First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 53(6), pages 1357-67, November.
  11. Arpad Abraham & Nicola Pavoni, 2008. "Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending: A Recursive Formulation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 781-803, October.
  12. Yahel Giat & Steve T. Hackman & Ajay Subramanian, 2010. "Investment under Uncertainty, Heterogeneous Beliefs, and Agency Conflicts," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1360-1404, April.
  13. Hugo Hopenhayn & Arantxa Jarque, 2007. "Moral hazard and persistence," Working Paper 07-07, Federal Reserve Bank of Richmond.
  14. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  15. Jovanovic, Boyan, 1979. "Job Matching and the Theory of Turnover," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 972-90, October.
  16. 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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