Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/217060 
Year of Publication: 
2019
Citation: 
[Journal:] Theoretical Economics [ISSN:] 1555-7561 [Volume:] 14 [Issue:] 4 [Publisher:] The Econometric Society [Place:] New Haven, CT [Year:] 2019 [Pages:] 1435-1482
Publisher: 
The Econometric Society, New Haven, CT
Abstract: 
We explore the conditions under which the "first-order approach" (FO-approach) can be used to characterize profit maximizing contracts in dynamic principal-agent models. The FO-approach works when the resulting FO-optimal contract satisfies a particularly strong form of monotonicity in types, a condition that is satisfied in most of the solved examples studied in the literature. The main result of our paper is to show that except for non-generic choices of the stochastic process governing the types' evolution, monotonicity and more generally incentive compatibility are necessarily violated by the FO-optimal contract if the frequency of interactions is sufficiently high (or equivalently if the discount factor, time horizon and persistence in types are sufficiently large). This suggests that the applicability of the FO-approach is problematic in environments in which expected continuation values are important relative to per-period payoffs. We present conditions under which a class of incentive compatible contracts that can be easily characterized is approximately optimal.
Subjects: 
Contract theory
dynamic contracts
JEL: 
D82
D86
Persistent Identifier of the first edition: 
Creative Commons License: 
cc-by-nc Logo
Document Type: 
Article

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