Dynamic Mechanism Design with Hidden Income and Hidden Auctions
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
CEPR Discussion Paper No. 4455
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. We show that the optimal contract can be implemented as a recursive direct mechanism with a vector of utility promises as the state variable. The standard recursive formulation suffers from a curse of dimensionality that arises from the interaction of hidden income and hidden actions; this curse can be overcome by introducing judiciously chosen utility bounds for deviation behavior off the equilibrium path. Our methods generalize to environments with multiple actions and additional states. The key to implementing these extensions is to introduce multiple layers of off-path utility bounds.
Number of Pages in PDF File: 66
Keywords: Mechanism design, dynamic contracts, recursive contracts
JEL Classification: C73, D82working papers series
Date posted: July 28, 2004
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo7 in 0.766 seconds