Optimal Dynamic Contracting: The First-Order Approach and Beyond

53 Pages Posted: 7 Nov 2012 Last revised: 29 Jun 2018

See all articles by Marco Battaglini

Marco Battaglini

Princeton University - Department of Economics; Centre for Economic Policy Research (CEPR)

Rohit Lamba

Pennsylvania State University - College of the Liberal Arts

Date Written: June 22, 2018

Abstract

We explore the conditions under which the “first-order approach” (FO-approach) can be used to characterize profit maximizing contracts in dynamic principal-agent models. The FO-approach works when the resulting FO-contract satisfies a particularly strong form of monotonicity in types, a condition that is satisfied in most of the solved examples used to motivate its use. The main result of our paper is to show that, except for non-generic choices of the stochastic process governing the types’ evolution, monotonicity and incentive compatibility are necessarily violated by the FO-optimal contract if the frequency of interactions is sufficiently high (or equivalently if the discount factor, time horizon and type persistence is sufficiently large). This suggests that the applicability of the FO-approach is problematic in environments in which expected continuation values are important relative to per period payoffs. We present conditions under which a class of incentive compatible contracts that can be easily characterized is approximately optimal.

Keywords: dynamic contracts, mechanism design, first-order approach

Suggested Citation

Battaglini, Marco and Lamba, Rohit, Optimal Dynamic Contracting: The First-Order Approach and Beyond (June 22, 2018). Available at SSRN: https://ssrn.com/abstract=2172414 or http://dx.doi.org/10.2139/ssrn.2172414

Marco Battaglini (Contact Author)

Princeton University - Department of Economics ( email )

213 Fisher Hall
Princeton, NJ 08544
United States
609-258-4002 (Phone)
609-258-6419 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Rohit Lamba

Pennsylvania State University - College of the Liberal Arts ( email )

University Park, PA 16802-3306
United States

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

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