### 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 language | English (US) |
---|---|

Pages (from-to) | 1435-1482 |

Number of pages | 48 |

Journal | Theoretical Economics |

Volume | 14 |

Issue number | 4 |

DOIs | |

State | Published - Nov 1 2019 |

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### All Science Journal Classification (ASJC) codes

- Economics, Econometrics and Finance(all)

### Cite this

*Theoretical Economics*,

*14*(4), 1435-1482. https://doi.org/10.3982/TE2355

}

*Theoretical Economics*, vol. 14, no. 4, pp. 1435-1482. https://doi.org/10.3982/TE2355

**Optimal dynamic contracting : The first-order approach and beyond.** / Battaglini, Marco; Lamba, Rohit.

Research output: Contribution to journal › Article

TY - JOUR

T1 - Optimal dynamic contracting

T2 - The first-order approach and beyond

AU - Battaglini, Marco

AU - Lamba, Rohit

PY - 2019/11/1

Y1 - 2019/11/1

N2 - 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.

AB - 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.

UR - http://www.scopus.com/inward/record.url?scp=85075945338&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=85075945338&partnerID=8YFLogxK

U2 - 10.3982/TE2355

DO - 10.3982/TE2355

M3 - Article

AN - SCOPUS:85075945338

VL - 14

SP - 1435

EP - 1482

JO - Theoretical Economics

JF - Theoretical Economics

SN - 1555-7561

IS - 4

ER -