Dynamic Mechanism Design with Hidden Income and Hidden Actions
Northwestern University - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); Institute for the Study of Labor (IZA)
Robert M. Townsend
MIT - Department of Economics
UCLA Department of Economics Working Paper No. 818
We develop general recursive methods to solve for optimal contracts in dynamic principal-agent environments with hidden states and hidden actions. In our baseline model, the principal observes nothing other than transfers. Nevertheless, optimal incentive-constrained insurance can be attained. Starting from a general mechanism with arbitrary communication, randomization, full history dependence, and without restrictions on preferences or technology, we show how the optimal contract can be efficiently implemented as a recursive direct mechanism. Our methods generalize to environments with multiple actions and additional states, some of which may be observable. The key to implementing these extensions is to introduce multiple layers of off-path utility bounds.
Number of Pages in PDF File: 63
Keywords: Moral Hazard, Public Reserves, Mechanism Design, Dynamic Contracts
JEL Classification: C63, C73, D82
Date posted: May 29, 2002
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