Tractability in Incentive Contracting
London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)
Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); New York University - Stern School of Business
April 25, 2011
Review of Financial Studies, Forthcoming
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.
Number of Pages in PDF File: 31
Keywords: Contract theory, executive compensation, incentives, principal-agent problem, closed forms, multiperiod contracts, multiperiod games.
JEL Classification: D2, D3, G34, J3
Date posted: July 22, 2008 ; Last revised: December 7, 2011