A Theory of Dynamic Contracting with Financial Constraints
51 Pages Posted: 1 Feb 2017 Last revised: 24 Sep 2019
Date Written: September 22, 2019
Financial constraints preclude many surplus producing economic transactions, and inhibit the growth of many others. This paper models financial constraints through the interaction of persistent private information and borrowing limitations for the agent. Specifically in a canonical model of dynamic screening with Markov types, the requirement of positivity of per-period utility is added as a stronger feasibility constraint. The distortions, defined as the wedge between optimal and efficient allocation, thus produced, increase over time with each successive "bad shock" and decrease with each "good shock". This overturns the standard result of decreasing distortions in dynamic mechanism design without financial constraints. At any point in the contract, an endogenous number of "good shocks" are required for the principal to provide some liquidity and then eventually for the contract to become efficient. Efficiency is reached almost surely. The average rate at which contract become efficient is decreasing in persistence of shocks; in particular, the iid model predicts a quick dissolution of financial constraints. This speaks to the relevance of modeling persistence in dynamic models of agency. A conceptual point is made on the fragile interpretation of positivity of stage utility as a limited liability constraint, and an extension where the principal can terminate the contract is provided. The problem is solved recursively, and building on the literature, a technical tool of finding the minimal subset of the recursive domain that houses the optimal contract is further developed.
Keywords: Dynamic Mechanism Design, Financial Contracting
JEL Classification: D82, D86, G00
Suggested Citation: Suggested Citation