Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring

56 Pages Posted: 3 Jan 2009 Last revised: 14 Sep 2016

See all articles by Tomasz Piskorski

Tomasz Piskorski

Columbia Business School - Finance and Economics

Mark M. Westerfield

University of Washington

Multiple version iconThere are 2 versions of this paper

Date Written: July 1, 2016

Abstract

We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. We present a novel characterization of optimal dynamic incentive provision when performance-based incentives may decline continuously to zero. Termination happens in equilibrium only if its costs are relatively low. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Keywords: Monitoring, Dynamic Contracts, Managerial Compensation, Moral Hazard, Endogenous Financing Constraints

JEL Classification: D82, D86, M52

Suggested Citation

Piskorski, Tomasz and Westerfield, Mark M., Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring (July 1, 2016). Columbia Business School Research Paper No. 13-26. Available at SSRN: https://ssrn.com/abstract=1470449 or http://dx.doi.org/10.2139/ssrn.1470449

Tomasz Piskorski

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Mark M. Westerfield (Contact Author)

University of Washington ( email )

Box 353200
Seattle, WA 98195
United States

HOME PAGE: http://www.markwesterfield.com

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