Optimal Incentive Contracts When Agents Can Save, Borrow, and Default

Posted: 2 Nov 1999

See all articles by David S. Bizer

David S. Bizer

Lehman Brothers

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Abstract

The standard Principal-Agent (PA) model assumes that the principal can control the agent's consumption profile. In an intertemporal setting, however, Rogerson (1985a) shows that given the optimal PA contract, the agent has an unmet precautionary demand for savings. Thus the standard PA model is invalid if the agent has access to credit markets.

In this paper we generalize the standard PA model to allow for saving and borrowing by the agent. We show that the impact of such access critically depends upon the treatment of default. If default is notpermitted, efficiency is strictly reduced by the introduction of credit markets, and the equilibrium level of borrowing or saving is indeterminate in the model.

If default is allowed, however, the optimal contract depends upon the level of bankruptcy protection in the economy, which is described by a minimum level of wage income. We show that there is an optimal intermediate range of bankruptcy protection. Within this range, allowing default increases efficiency in the economy relative to the case of no default. Also, the model predicts specific levels of consumer debt, interest and default rates as function of the level of bankruptcy protection level.

JEL Classification: D80, G21, G28, J30

Suggested Citation

Bizer, David S. and DeMarzo, Peter M., Optimal Incentive Contracts When Agents Can Save, Borrow, and Default. Journal of Financial Intermediation, Vol. 8, Iss. 4. Available at SSRN: https://ssrn.com/abstract=191514

David S. Bizer

Lehman Brothers ( email )

3 World Financial Center 6th Floor
New York, NY 10285
United States
212-526-0900 (Phone)
212-526-2755 (Fax)

Peter M. DeMarzo (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)

HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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