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Ambiguity in dynamic contracts

Martin Szydlowski and Ji Hee Yoon

Journal of Economic Theory, 2022, vol. 199, issue C

Abstract: We study a continuous-time principal-agent model in which the principal is ambiguity averse about the agent's effort cost. The robust contract generates a seemingly excessive pay-performance sensitivity. The worst-case effort cost is high after good performance, but low after bad performance, which leads to overcompensation and undercompensation respectively and provides a new rationale for performance-sensitive debt. We also characterize the agent's incentives when the contract is misspecified, i.e., he is offered the robust contract, but his true effort cost differs from the worst case. Then, termination can induce shirking, the strength of incentives is hump-shaped, and agents close to firing prefer riskier projects, while those close to getting paid prefer safer ones. This feature resembles careers in organizations, most notably risk-shifting and the quiet life.

Keywords: Principal-agent model; Ambiguity; Continuous time; Overcompensation (search for similar items in EconPapers)
JEL-codes: C61 D86 M12 M53 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.jet.2021.105229

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