Working Paper: NBER ID: w16649
Authors: Julien Prat; Boyan Jovanovic
Abstract: We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's 'quality', the Pareto frontier shifts inwards with better information. \nCommitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.
Keywords: incentive contracts; parameter uncertainty; moral hazard; commitment
JEL Codes: L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| constant unknown parameter (C29) | exacerbated moral hazard concerns (E71) |
| agent shirking (D82) | belief manipulation (D83) |
| belief manipulation (D83) | principal inferring lower productivity (D29) |
| principal inferring lower productivity (D29) | agent exerting less effort (D29) |
| improved information about agent's quality (L15) | outward shift of Pareto frontier (D69) |
| experience accumulation (C41) | decline in wage volatility (J39) |
| better information (D83) | easier provision of incentives (M52) |