Tractability in Incentive Contracting

Xavier Gabaix and Alex Edmans

No 7578, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: This paper identifies a class of multiperiod agency problems in which the optimal contract is tractable (attainable in closed form). By modeling the noise before the action in each period, we force the contract to provide sufficient incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We thus extend the tractable contracts of Holmstrom and Milgrom (1987) to settings that do not require exponential utility, a pecuniary cost of effort, Gaussian noise or continuous time. The contract's functional form is independent of the noise distribution. Moreover, if the cost of effort is pecuniary (multiplicative), the contract is linear (log-linear) in output and its slope is independent of the noise distribution, utility function and reservation utility. In a two-stage contracting game, the optimal target action depends on the costs and benefits of the environment, but is independent of the noise realization.

Keywords: Closed forms; Contract theory; Dispersive order; Executive compensation; Incentives; Principal-agent problem; Subderivative (search for similar items in EconPapers)
JEL-codes: D2 D3 G34 J3 (search for similar items in EconPapers)
Date: 2009-11
New Economics Papers: this item is included in nep-bec, nep-cta and nep-upt
References: View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Tractability in Incentive Contracting (2011)
Working Paper: Tractability in Incentive Contracting (2010)
Working Paper: Tractability in Incentive Contracting (2010)
Working Paper: Tractability in Incentive Contracting (2009)
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