A Note on the Dynamics of Incentive Contracts
Laffont and Tirole  show that when the uncertainty about the agent's ability is small, the equilibrium must involve a large amount of pooling, but it is not necessary to be a partition equilibrium. They construct a nonpartition continuation equilibrium for a given first-period menu of contracts and conjecture that this continuation equilibrium need not be suboptimal for the whole game under small uncertainty. We show that, irrespective of the amount of uncertainty, this nonpartition continuation equilibrium generates a smaller payoff for the principal than a different menu of contracts with a partition continuation equilibrium. In this sense, Laffont and Tirole's menu of contracts, giving rise to a nonpartition continuation equilibrium, is not optimal. An intuition behind this result is provided that may shed some light on the problem of dynamic contracting without commitment.
|Date of creation:||Aug 2007|
|Date of revision:||Feb 2008|
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- Laffont, Jean-Jacques & Tirole, Jean, 1986.
"Using Cost Observation to Regulate Firms,"
Journal of Political Economy,
University of Chicago Press, vol. 94(3), pages 614-641, June.
- Jean Tirole & Jean-Jaques Laffont, 1985. "Using Cost Observation to Regulate Firms," Working papers 368, Massachusetts Institute of Technology (MIT), Department of Economics.
- Bester, Helmut & Strausz, Roland, 2001. "Contracting with Imperfect Commitment and the Revelation Principle: The Single Agent Case," Econometrica, Econometric Society, vol. 69(4), pages 1077-1098, July.
- Caillaud, Bernard & Mezzetti, Claudio, 2004. "Equilibrium reserve prices in sequential ascending auctions," Journal of Economic Theory, Elsevier, vol. 117(1), pages 78-95, July.
- Laffont, Jean-Jacques & Tirole, Jean, 1988. "The Dynamics of Incentive Contracts," Econometrica, Econometric Society, vol. 56(5), pages 1153-1175, September.