A Theory of Dynamic Contracting with Financial Constraints
48 Pages Posted: 1 Feb 2017 Last revised: 19 Feb 2019
Date Written: December 22, 2018
We study a dynamic principal-agent model where the agent has access to a persistent private technology but is strapped for cash. Financial constraints are generated by the periodic interaction between incentives (private information) and a strong notion of feasibility (being strapped for cash). This interaction produces dynamic distortions that are a sum of two effects: backloading of incentives and illiquidity. Bad technology shocks increase distortions and monotonically push the optimal contract further away from efficiency. An endogenous number of good shocks is required for the contract to become liquid, and then eventually efficient. Efficiency is an absorbing state that is reached almost surely. Persistence of private information increases the variance of total economic surplus generated by the model, and decreases the rate at which surplus converges to its efficient value. The key predictions continue to hold in the continuous time setting. A simple economic implementation of the optimal contract is also provided.
Keywords: Dynamic Mechanism Design, Financial Contracting
JEL Classification: D82, D86, G00
Suggested Citation: Suggested Citation