Optimal dynamic contracts with moral hazard and costly monitoring

Tomasz Piskorski and Mark Westerfield ()

Journal of Economic Theory, 2016, vol. 166, issue C, 242-281

Abstract: We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. We present a novel characterization of optimal dynamic incentive provision when performance-based incentives may decline continuously to zero. Termination happens in equilibrium only if its costs are relatively low. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Keywords: Monitoring; Dynamic contracts; Managerial compensation; Moral hazard; Endogenous financing constraints (search for similar items in EconPapers)
JEL-codes: D82 D86 M52 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (28)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:166:y:2016:i:c:p:242-281

DOI: 10.1016/j.jet.2016.08.003

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