Summary
In this paper we study a repeated principal-agent situation with moral hazard. We focus on a class of incentive schemes, calledbankruptcy contracts. The agent is “scored” in each period, and is paid a fixed wage per period until the current score falls to zero, at which time the agent is terminated and the principal hires a new agent. The agent's current score at any time equals an initial score, plus the total output up to that time, minus an amount that is proportional to the total time. With standard assumptions about the utility functions of the principal and agent, we characterize the second-best bankruptcy contracts and show that in such a contract, the principal pays the agent an efficiency wage. We also demonstrate that such contracts lead to approximately first-best (Pareto efficient) outcomes if the principal and agent are sufficiently patient (have small discount rates). Most importantly, if the two players have a common discount rateδ, then the loss of efficiency under the second-best bankruptcy contract goes to zero at least as fast asO(gd 1/2lnδ). In order to obtain increased precision, the analysis is carried out in a continuous-time framework.
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This is a considerably revised version of a manuscript titled “Principal Agent Games in Continuous Time”. We have benefited from the comments of seminar participants (on the earlier version) at Columbia, Northwestern, Illinois and Stony Brook. The revised version benefited from a presentation to the Game Theory Conference at Ohio State, July 1990. We would like to acknowledge helpful comments from Dilip Abreu, Tatsuro Ichiishi, Eric Maskin, William Rogerson and Aloysius Siow as well as an anonymous referee. This paper was begun while the first author was at AT&T Bell Laboratories and completed while visiting the Department of Economics at the University of Rochester; the two organizations are thanked for all help rendered.
The views expressed here are those of the authors, and not necessarily those of AT&T Bell Laboratories.
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Dutta, P.K., Radner, R. Optimal principal agent contracts for a class of incentive schemes: a characterization and the rate of approach to efficiency. Econ Theory 4, 483–503 (1994). https://doi.org/10.1007/BF01213620
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DOI: https://doi.org/10.1007/BF01213620