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Moral hazard and persistence

Hugo Hopenhayn and Arantxa Jarque

No 07-07, Working Paper from Federal Reserve Bank of Richmond

Abstract: We study a multiperiod principal-agent problem with moral hazard in which effort is persistent: the agent is required to exert effort only in the initial period of the contract, and this effort determines the conditional distribution of output in the following periods. We provide a characterization of the optimal dynamic compensation scheme. As in a static moral hazard problem, consumption ? regardless of time period ? is ranked according to likelihood ratios of output histories. As in most dynamic models with asymmetric information, the inverse of the marginal utility of consumption satisfies the martingale property derived in Rogerson (1985). Under the assumption of i.i.d. output we show that (i) incentives are concentrated in the later periods of the contract, implying an increase of the variance of compensation over time; (ii) the cost of implementing high effort decreases when there is an increase in either the duration or the intensity of persistence (i.e., how long and how strongly effort affects the distribution of output, respectively); and (iii) under infinite duration the cost gets arbitrarily close to that of the first best.

Keywords: Microeconomics (search for similar items in EconPapers)
Date: 2007, Revised 2007
New Economics Papers: this item is included in nep-bec
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Working Paper: Moral Hazard and Persistence (2006)
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