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Dynamic Mechanism Design with Hidden Income and Hidden Actions

UCLA Department of Economics Working Paper No. 818

63 Pages Posted: 29 May 2002  

Matthias Doepke

Northwestern University - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); IZA Institute of Labor Economics

Robert M. Townsend

MIT - Department of Economics

Date Written: April 2002

Abstract

We develop general recursive methods to solve for optimal contracts in dynamic principal-agent environments with hidden states and hidden actions. In our baseline model, the principal observes nothing other than transfers. Nevertheless, optimal incentive-constrained insurance can be attained. Starting from a general mechanism with arbitrary communication, randomization, full history dependence, and without restrictions on preferences or technology, we show how the optimal contract can be efficiently implemented as a recursive direct mechanism. Our methods generalize to environments with multiple actions and additional states, some of which may be observable. The key to implementing these extensions is to introduce multiple layers of off-path utility bounds.

Keywords: Moral Hazard, Public Reserves, Mechanism Design, Dynamic Contracts

JEL Classification: C63, C73, D82

Suggested Citation

Doepke, Matthias and Townsend, Robert M., Dynamic Mechanism Design with Hidden Income and Hidden Actions (April 2002). UCLA Department of Economics Working Paper No. 818. Available at SSRN: https://ssrn.com/abstract=311547 or http://dx.doi.org/10.2139/ssrn.311547

Matthias Doepke (Contact Author)

Northwestern University - Department of Economics ( email )

2003 Sheridan Road
Evanston, IL 60208
United States

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Robert M. Townsend

MIT - Department of Economics ( email )

Bldg. E52-252c
50 Memorial Drive
Cambridge, MA 02142
United States
617-452-3722 (Phone)
617-253-1330 (Fax)

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