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A theory of dynamic contracting with financial constraints

Ilia Krasikov and Rohit Lamba

Journal of Economic Theory, 2021, vol. 193, issue C

Abstract: Financial constraints preclude many surplus producing economic transactions, and inhibit the growth of many others. This paper models financial constraints as the interaction of two forces: the agent has persistent private information and is strapped for cash. The wedge between the optimal and efficient allocation, termed distortion, increases over time with each successive “bad shock” and decreases with each “good shock”. At any point in the contract, an endogenous number of “good shocks” are required for the principal to provide some liquidity and then eventually for the contract to become efficient. Efficiency is reached almost surely. The average rate at which contract becomes efficient is decreasing in persistence of shocks; in particular, the iid model predicts a quick dissolution of financial constraints. This speaks to the relevance of modeling persistence in dynamic models of agency. The problem is solved recursively, and building on the literature, a technical tool of finding the minimal subset of the recursive domain that houses the optimal contract is further developed.

Keywords: Dynamic mechanism design; Financial constraints; Asymmetric information (search for similar items in EconPapers)
JEL-codes: D80 D82 G32 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jet.2021.105196

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