Dynamic Mechanism Design with Hidden Income and Hidden Auctions

Matthias Doepke () and Robert M. Townsend

No 4455, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We develop general recursive methods to solve for optimal contracts in dynamic principal-agent environments with hidden states and hidden actions. In our baseline model, the principal observes nothing other than transfers. Nevertheless, optimal incentive-constrained insurance can be attained. We show that the optimal contract can be implemented as a recursive direct mechanism with a vector of utility promises as the state variable. The standard recursive formulation suffers from a curse of dimensionality that arises from the interaction of hidden income and hidden actions; this curse can be overcome by introducing judiciously chosen utility bounds for deviation behaviour off the equilibrium path. Our methods generalize to environments with multiple actions and additional states. The key to implementing these extensions is to introduce multiple layers of off-path utility bounds.

Keywords: dynamic contracts; mechanism design; recursive contracts (search for similar items in EconPapers)
JEL-codes: C73 D82 (search for similar items in EconPapers)
Date: 2004-06
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Related works:
Working Paper: Dynamic Mechanism Design With Hidden Income and Hidden Actions (2002)
Journal Article: Dynamic mechanism design with hidden income and hidden actions (2006)
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