Experimentation and Signal Dampening in Agency--The Ratchet Effect Revisited

25 Pages Posted: 8 Mar 1999  

Thomas D. Jeitschko

Michigan State University - Department of Economics

Leonard J. Mirman

University of Virginia - Department of Economics

Egas M. Salgueiro

Universidade de Aveiro, S.A.G.E.I.

Date Written: November 1998

Abstract

The dynamics of incentive contracts under asymmetric information have long been an important topic in economics. We address this topic in this paper by considering a stochastic, two-period principal-agent relationship, in which the true state of the world can take on two possible values and is the same in each period. We study contracts that are short term, so that after the first period the principal designs a second contract, taking the information available about the state of the world at that stage into account--that is, the standard framework in which the "ratchet effect" occurs.

Two significant changes emerge when compared to deterministic environments: First, if production is sufficiently noisy, a fully separating first period contract is optimal. The second change is that, unlike the deterministic setting where the high type's target is fixed over time, in a stochastic environment, the high type's target is ratcheted upward in the course of the interaction. This is the result of two opposing incentives of the principal: First, the principal experiments in order to increase the flow of information; and second, the principal attempts to dampen the first period signal to reduce up-front payments.

JEL Classification: D8, L5, H57

Suggested Citation

Jeitschko, Thomas D. and Mirman, Leonard J. and Salgueiro, Egas M., Experimentation and Signal Dampening in Agency--The Ratchet Effect Revisited (November 1998). Available at SSRN: https://ssrn.com/abstract=149310 or http://dx.doi.org/10.2139/ssrn.149310

Thomas D. Jeitschko (Contact Author)

Michigan State University - Department of Economics ( email )

110 Marshall-Adams Hall
East Lansing, MI 48824
United States
517-355-8302 (Phone)
517-432-1068 (Fax)

HOME PAGE: http://www.msu.edu/~jeitschk/

Leonard J. Mirman

University of Virginia - Department of Economics ( email )

1818 Winston Rd
Charlottesville, VA
United States

Egas Manuel Da Silva Salgueiro

Universidade de Aveiro, S.A.G.E.I. ( email )

3810-Aveiro
Portugal

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