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Ambiguity in Dynamic Contracts

  • Martin Szydlowski

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

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Paper provided by Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1543.

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Date of creation: 16 Jan 2012
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Handle: RePEc:nwu:cmsems:1543
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  1. Larry Epstein & Martin Schneider, 2002. "Learning Under Ambiguity," RCER Working Papers 497, University of Rochester - Center for Economic Research (RCER), revised Mar 2005.
  2. 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.
  3. 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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  14. Brian J. Hall & Kevin J. Murphy, 2003. "The Trouble with Stock Options," NBER Working Papers 9784, National Bureau of Economic Research, Inc.
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  16. Dirk Bergemann & Karl Schlag, 2005. "Robust Monopoly Pricing," Cowles Foundation Discussion Papers 1527RR, Cowles Foundation for Research in Economics, Yale University, revised Sep 2008.
  17. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  18. 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.
  19. Strulovici, Bruno & Szydlowski, Martin, 2012. "On the Smoothness of Value Functions," MPRA Paper 36326, University Library of Munich, Germany, revised 31 Jan 2012.
  20. 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.
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