Tractability in Incentive Contracting

Edmans, Alex; Gabaix, Xavier

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Tractability in Incentive Contracting

Review of Financial Studies, Forthcoming

31 Pages Posted: 22 Jul 2008 Last revised: 30 Jun 2011

See all articles by Alex Edmans

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

There are 3 versions of this paper

Date Written: April 25, 2011

Abstract

This paper develops a framework that delivers tractable (i.e. closed-form) optimal contracts, with few restrictions on the utility function, cost of effort or noise distribution. By modeling the noise before the action in each period, we force the contract to provide correct incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We illustrate the potential usefulness of our setup by a series of examples relating to CEO incentives. In particular, the model derives predictions for the optimal measure of incentives and whether the contract should be convex, concave or linear.

Keywords: Contract theory, executive compensation, incentives, principal-agent problem, closed forms, multiperiod contracts, multiperiod games.

JEL Classification: D2, D3, G34, J3

Suggested Citation: Suggested Citation

Edmans, Alex and Gabaix, Xavier, Tractability in Incentive Contracting (April 25, 2011). Review of Financial Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1164342