Punish Underperformance with Suspension: Optimal Dynamic Contracts in the Presence of Switching Cost

Ping Cao (), Peng Sun () and Feng Tian ()
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Ping Cao: International Institute of Finance, School of Management, University of Science and Technology of China, Hefei 230026, China
Peng Sun: The Fuqua School of Business, Duke University, Durham, North Carolina 27708
Feng Tian: Faculty of Business and Economics, University of Hong Kong, Hong Kong

Management Science, 2024, vol. 70, issue 5, 3020-3037

Abstract: This paper studies a dynamic principal–agent setting in which the principal needs to dynamically schedule an agent to work or be suspended. When the agent is directed to work and exert effort, the arrival rate of a Poisson process is increased, which increases the principal’s payoff. Suspension, on the other hand, serves as a threat to the agent by delaying future payments. A key feature of our setting is a switching cost whenever the suspension stops and the work starts again. We formulate the problem as an optimal control model with switching and fully characterize the optimal control policies/contract structures under different parameter settings. Our analysis shows that, when the switching cost is not too high, the optimal contract demonstrates a generalized control-band structure. The length of each suspension episode, on the other hand, is fixed. Overall, the optimal contract is easy to describe, compute, and implement.

Keywords: dynamic contract; jump process; optimal control; switching cost (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:70:y:2024:i:5:p:3020-3037

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