Tractability in Incentive Contracting
Review of Financial Studies, Forthcoming
31 Pages Posted: 22 Jul 2008 Last revised: 7 Dec 2011
Date Written: April 25, 2011
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