Optimal dynamic contracting: The first-order approach and beyond

Marco Battaglini, Rohit Lamba

Research output: Contribution to journalArticle

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 nongeneric 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 also present conditions under which a class of incentive compatible contracts that can be easily characterized is approximately optimal.

Original languageEnglish (US)
Pages (from-to)1435-1482
Number of pages48
JournalTheoretical Economics
Volume14
Issue number4
DOIs
Publication statusPublished - Nov 1 2019

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All Science Journal Classification (ASJC) codes

  • Economics, Econometrics and Finance(all)

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