Optimal Monitoring Schedule in Dynamic Contracts
Operations Research, accepted for publication
43 Pages Posted: 19 Sep 2017 Last revised: 2 Jul 2020
Date Written: September 16, 2017
Abstract
Consider a setting in which a principal induces effort from an agent to reduce the arrival rate of a Poisson process of adverse events. The effort is costly to the agent, and unobservable to the principal, unless the principal is monitoring the agent. Monitoring ensures effort but is costly to the principal. The optimal contract involves monetary payments and monitoring sessions that depend on past arrival times. We formulate the problem as a stochastic optimal control model and solve the problem analytically. The optimal schedules of payment and monitoring demonstrate different structures depending on model parameters, and may involve monitoring for a random period of time. Overall, the optimal dynamic contracts are simple to describe, easy to compute and implement, and intuitive to explain.
Keywords: Dynamic Contract, Moral Hazard, Principal-agent Model, Optimal Control, Continuous Time, Costly State Verification
JEL Classification: D86, C73, C61
Suggested Citation: Suggested Citation