Timing of Effort and Reward: Three-Sided Moral Hazard in a Continuous-Time Model

Abstract:     
This paper studies a three-sided moral hazard problem with one agent exerting upfront effort and two agents exerting ongoing effort in a continuous-time model. The agents' effort jointly affects the probability of survival and thus the expected cash flow of the project. In the optimal contract, the timing of payments reflects the timing of effort: payments for upfront effort precede payments for ongoing effort. Several patterns are possible for the cash allocation between the two agents with ongoing effort. In one case where the two agents face equally severe moral hazard, they share the cash flow equally at each point of time. In another case where the two agents have different severities of moral hazard, their payments are sequential. In a more general case, the two agents with ongoing effort split the cash flow first over time and then over quantity at each point of time. This study provides a framework to understanding a broad set of contracting issues in business. The characteristics suggested in the optimal contract help us identify the causes of business failures such as the recent debacle of Mortgage-Backed Securities (MBS).

Number of Pages in PDF File: 39

Keywords: Optimal Contract, Incentives, Three-sided moral hazard, Continuous time

JEL Classification: D82, M52

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