Dynamic Incentive Contracts Under Parameter Uncertainty / Julien Prat, Boyan Jovanovic.

Format:

Book

Author/Creator:

Prat, Julien.

Contributor:

National Bureau of Economic Research.

Jovanovic, Boyan.

Series:

Working Paper Series (National Bureau of Economic Research) no. w16649.

NBER working paper series no. w16649

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2010.

Summary:

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.

Commitment 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.

Notes:

Print version record

December 2010.