Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring

Abstract:     
We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. Termination happens in equilibrium only if its costs are relatively low. Optimal monitoring intensity may decline as performance deteriorates because an agent with a smaller inside stake has less to lose. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Number of Pages in PDF File: 42

Keywords: Monitoring, Dynamic Contracts, Managerial Compensation, Moral Hazard

JEL Classification: D82, D86, M52

working papers series