Dynamic Costs and Moral Hazard: A Duality Based Approach

50 Pages Posted: 7 Sep 2012 Last revised: 9 Sep 2016

See all articles by Guy Arie

Guy Arie

University of Rochester - Simon Business School

Date Written: August 8, 2016

Abstract

The marginal cost of effort often increases as effort is exerted. In a dynamic moral hazard setting, dynamically increasing costs create information asymmetry. This paper characterizes the optimal contract and helps explain the popular yet thus far puzzling use of non-linear incentives, for example in sales-force compensation. The result is obtained by complementing the standard dynamic program with a novel dynamic dual formulation. The dual program is monotonic and sub-modular, providing stronger results, including a proof for the sufficiency of one shot deviations.

Keywords: Dynamic moral hazard, nonlinear incentives, private information, dynamic mechanism design, duality, linear programming, stochastic programming, dynamic programming

JEL Classification: D86, D82, C61

Suggested Citation

Arie, Guy, Dynamic Costs and Moral Hazard: A Duality Based Approach (August 8, 2016). Simon School Working Paper No. FR 12-11. Available at SSRN: https://ssrn.com/abstract=2142120 or http://dx.doi.org/10.2139/ssrn.2142120

Guy Arie (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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