Working Paper: NBER ID: w15545
Authors: Alex Edmans; Xavier Gabaix
Abstract: This paper identifies a class of multiperiod agency problems in which the optimal contract is tractable (attainable in closed form). By modeling the noise before the action in each period, we force the contract to provide sufficient incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We thus extend the tractable contracts of Holmstrom and Milgrom (1987) to settings that do not require exponential utility, a pecuniary cost of effort, Gaussian noise or continuous time. The contract's functional form is independent of the noise distribution. Moreover, if the cost of effort is pecuniary (multiplicative), the contract is linear (log-linear) in output and its slope is independent of the noise distribution, utility function and reservation utility. In a two-stage contracting game, the optimal target action depends on the costs and benefits of the environment, but is independent of the noise realization.
Keywords: Incentive Contracts; Agency Problems; Contract Theory
JEL Codes: D2; G34; J3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal contract is tractable (D86) | principal can derive a contract that effectively incentivizes the agent (D86) |
| timing of noise before action (C41) | incentive compatibility holds state-by-state (H73) |
| timing assumption satisfied (C41) | principal can derive a contract that effectively incentivizes the agent (D86) |
| structure of the contract (L14) | incentives it generates (O31) |
| cost of effort expressed pecuniarily (J30) | contract will be linear in output (D86) |
| maximum effort principle applies (D20) | principal will always wish to implement maximum effort (D29) |
| principal's choice of contract (M55) | agent's incentives and actions (D82) |
| theoretical results (C62) | appropriate output measure for CEOs is percentage stock return (M12) |