NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Dynamic Incentive Contracts Under Parameter Uncertainty

Julien Prat, Boyan Jovanovic

NBER Working Paper No. 16649
Issued in December 2010
NBER Program(s):   IO

We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's 'quality', the Pareto frontier shifts inwards with better information.

Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.

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Document Object Identifier (DOI): 10.3386/w16649

Published: “Dynamic Contracts…Quality Unknown.” (w/Prat) TE forthc.

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