IDEAS home Printed from https://ideas.repec.org/p/nwu/cmsems/1543.html
   My bibliography  Save this paper

Ambiguity in Dynamic Contracts

Author

Listed:
  • Martin Szydlowski

Abstract

I study a dynamic principal agent model in which the effort cost of the agent is unknown to the principal. The principal is ambiguity averse, and designs a contract which is robust to the worst case effort cost process. Ambiguity divides the contract into two regions. After sufficiently high performance, the agent reaches the over-compensation region, where he receives excessive benefits compared to the contract without ambiguity, while after low performance, he enters the under-compensation region. Ambiguity also causes a disconnect between the current effort cost and the strength of incentives. That is, even when the agent is under-compensated, his incentives are as strong as in the over-compensation region, since the principal fears the agent might shirk otherwise. Under ambiguity, the agent’s true effort cost does not need to equal the worst-case. I analyze the agent’s incentives for this case, and show that the possibility of firing is detrimental to the agent’s incentives. I study several extensions concerning the timing structure and the nature of the principal’s ambiguity aversion. JEL Code: D82, D86, M52

Suggested Citation

  • Martin Szydlowski, 2012. "Ambiguity in Dynamic Contracts," Discussion Papers 1543, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  • Handle: RePEc:nwu:cmsems:1543
    as

    Download full text from publisher

    File URL: http://www.kellogg.northwestern.edu/research/math/papers/1543.pdf
    File Function: main text
    Download Restriction: no

    References listed on IDEAS

    as
    1. Bruno Biais & Thomas Mariotti & Jean-Charles Rochet & StÈphane Villeneuve, 2010. "Large Risks, Limited Liability, and Dynamic Moral Hazard," Econometrica, Econometric Society, vol. 78(1), pages 73-118, January.
    2. Oyer, Paul & Schaefer, Scott, 2011. "Personnel Economics: Hiring and Incentives," Handbook of Labor Economics, Elsevier.
    3. Xavier Gabaix & Augustin Landier, 2008. "Why has CEO Pay Increased So Much?," The Quarterly Journal of Economics, Oxford University Press, vol. 123(1), pages 49-100.
    4. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    5. Zengjing Chen & Larry Epstein, 2002. "Ambiguity, Risk, and Asset Returns in Continuous Time," Econometrica, Econometric Society, vol. 70(4), pages 1403-1443, July.
    6. PETER M. DeMARZO & YULIY SANNIKOV, 2006. "Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model," Journal of Finance, American Finance Association, vol. 61(6), pages 2681-2724, December.
    7. Bose, Subir & Daripa, Arup, 2009. "A dynamic mechanism and surplus extraction under ambiguity," Journal of Economic Theory, Elsevier, pages 2084-2114.
    8. Tomasz Piskorski & Alexei Tchistyi, 2011. "Stochastic House Appreciation and Optimal Mortgage Lending," Review of Financial Studies, Society for Financial Studies, pages 1407-1446.
    9. Daniel Garrett & Alessandro Pavan, 2014. "Dynamic Managerial Compensation: On the Optimality of Seniority-based Schemes," Discussion Papers 1579, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    10. Larry G. Epstein & Martin Schneider, 2007. "Learning Under Ambiguity," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1275-1303.
    11. Dirk Bergemann & Karl Schlag, 2012. "Robust Monopoly Pricing," World Scientific Book Chapters,in: Robust Mechanism Design The Role of Private Information and Higher Order Beliefs, chapter 13, pages 417-441 World Scientific Publishing Co. Pte. Ltd..
    12. Dirk Bergemann & Karl H. Schlag, 2012. "Pricing Without Priors," World Scientific Book Chapters,in: Robust Mechanism Design The Role of Private Information and Higher Order Beliefs, chapter 12, pages 405-415 World Scientific Publishing Co. Pte. Ltd..
    13. Brian J. Hall & Kevin J. Murphy, 2003. "The Trouble with Stock Options," Journal of Economic Perspectives, American Economic Association, pages 49-70.
    14. repec:nwu:cmsems:1542 is not listed on IDEAS
    15. Brian J. Hall & Kevin J. Murphy, 2003. "The Trouble with Stock Options," NBER Working Papers 9784, National Bureau of Economic Research, Inc.
    16. Daniel Garrett & Alessandro Pavan, 2009. "Dynamic Managerial Compensation: A Mechanism Design Approach," 2009 Meeting Papers 375, Society for Economic Dynamics.
    17. Alfredo Di Tillio & Nenad Kos & Matthias Messner, 2012. "The Design of Ambiguous Mechanisms," Working Papers 446, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    18. Bruno Strulovici & Martin Szydlowski, 2012. "On the Smoothness of Value Functions," Discussion Papers 1542, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    19. Yahel Giat & Steve T. Hackman & Ajay Subramanian, 2010. "Investment under Uncertainty, Heterogeneous Beliefs, and Agency Conflicts," Review of Financial Studies, Society for Financial Studies, pages 1360-1404.
    20. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    21. 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.
    22. Daniel F. Garrett & Alessandro Pavan, 2012. "Managerial Turnover in a Changing World," Journal of Political Economy, University of Chicago Press, vol. 120(5), pages 879-925.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Wang, Cheng, 2011. "Termination of dynamic contracts in an equilibrium labor market model," Journal of Economic Theory, Elsevier, vol. 146(1), pages 74-110, January.
    2. Spear, Stephen & Young, Warren, 2017. "Generalizations Of Optimal Growth Theory: Stochastic Models, Mathematics, And Metasynthesis," Macroeconomic Dynamics, Cambridge University Press, pages 515-544.
    3. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    4. repec:eee:mateco:v:71:y:2017:i:c:p:74-91 is not listed on IDEAS
    5. Miao, Jianjun & Zhang, Yuzhe, 2015. "A duality approach to continuous-time contracting problems with limited commitment," Journal of Economic Theory, Elsevier, pages 929-988.
    6. Jianjun Miao & Alejandro Rivera, 2016. "Robust Contracts in Continuous Time," Econometrica, Econometric Society, vol. 84, pages 1405-1440, July.

    More about this item

    Keywords

    Dynamic contract; principal-agent model; ambiguity aversion; continuous time JEL Classification Numbers: 1543;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nwu:cmsems:1543. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Fran Walker). General contact details of provider: http://edirc.repec.org/data/cmnwuus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.