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Optimal Long-term Contracting with Learning

Author

Listed:
  • Jianfeng Yu

    (University of Minnesota)

  • Bin Wei

    (Federal Reserve Board)

  • Zhiguo He

    (University of Chicago, Booth School of Business)

Abstract

This paper introduces profitability uncertainty into an infinite-horizon variation of the classic Holmstrom and Milgrom (1987) model, and studies optimal dynamic contracting with endogenous learning. The agent's potential belief manipulation leads to the hidden information problem, which makes incentive provisions intertemporally linked in the optimal contract. We reduce the contracting problem into a dynamic programming problem with one state variable, and characterize the optimal contract with an ordinary differential equation. In the benchmark case of Holmstrom and Milgrom (1987) without learning, the optimal effort is constant, and the optimal contract is linear. In contrast, in our model with endogenous learning, the optimal effort policy becomes history dependent, and decreases over time on average. Moreover, we show that the optimal contract exhibits an option-like feature in that the incentives rise after good performance shocks.

Suggested Citation

  • Jianfeng Yu & Bin Wei & Zhiguo He, 2012. "Optimal Long-term Contracting with Learning," 2012 Meeting Papers 221, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:221
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    References listed on IDEAS

    as
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    Cited by:

    1. repec:eee:eecrev:v:98:y:2017:i:c:p:424-441 is not listed on IDEAS
    2. repec:spr:joecth:v:66:y:2018:i:1:d:10.1007_s00199-017-1056-x is not listed on IDEAS
    3. Jianjun Miao & Alejandro Rivera, 2016. "Robust Contracts in Continuous Time," Econometrica, Econometric Society, vol. 84, pages 1405-1440, July.
    4. Vasama, Suvi, 2017. "On moral hazard and persistent private information," Research Discussion Papers 15/2017, Bank of Finland.

    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts

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