Dynamic Screening: A Role for Up-or-Out Contracts

Elena Pastorino () and Braz Camargo ()

No 766, 2005 Meeting Papers from Society for Economic Dynamics

Abstract: We analyze a dynamic principal-agent model where an infinitely-lived principal faces a sequence of finitely-lived agents who differ in their ability to produce output. The ability of an agent is initially unknown to both him and the principal. An agent's effort affects the information on ability that is conveyed by performance. We characterize the equilibrium contracts and show that they display short-term commitment to employment when the impact of effort on output is persistent but delayed. By providing insurance against early termination, commitment encourages agents to exert effort, and thus improves on the principal's ability to identify their talent. We argue that this helps explain the use of probationary appointments in environments in which there exists uncertainty about individual ability.

Date: 2005

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