A Theory of Dynamic Contracting with Financial Constraints

We study a dynamic principal-agent model where the agent has access to a persistent private technology but is strapped for cash. Financial constraints are generated by the periodic interaction between incentives (private information) and feasibility (being strapped for cash).This interaction produces dynamic distortions that are a sum of two effects: backloading of incentives and illiquidity. Bad technology shocks increase distortions and monotonically push the agent further away from efficiency. An endogenous number of good shocks is required for the agent to become liquid, and eventually for the contract to become efficient. Efficiency is an absorbing state that is reached almost surely. The optimal allocation can be implemented through a mechanism which is precisely pinned down by a dynamic information operator. The shares of principal and agent in the net present value of economic surplus are endogenous to the evolution of technology shocks. Surplus itself is increasing in the share of the agent, and in his type contingent utility spread. By comparing the agent’s utility with and without financial constraints, the model provides a foundation for the usefulness of limited liability in dynamic contracts