Of Restarts and Shutdowns: Dynamic Contracts With Unequal Discounting

35 Pages Posted: 19 Mar 2018

See all articles by Ilia Krasikov

Ilia Krasikov

Pennsylvania State University

Rohit Lamba

Pennsylvania State University - College of the Liberal Arts

Thomas Mettral

Humboldt University of Berlin

Date Written: March 17, 2018

Abstract

A large supplier (principal) contracts with a small firm (agent) to repeatedly provide working capital in return for payments. The total factor productivity of the agent is private and follows a Markov process. Moreover, the agent is less patient than the principal. We solve for the optimal contract in this environment. Distortions are pervasive and efficiency unattainable. The optimal contract is characterized by two key properties: restart and shutdown, which capture various aspects of contracts offered in the marketplace. The optimal distortions are completely pinned down by the number of low TFP shocks since the last high shock. Once a high shock arrives, the contract loses memory and repeats the same cycle, we call this endogenous resetting feature restart. If ex ante agency frictions are high, the principal commits to not serving the low type, we call this shutdown. The principal prefers a patient agent if the interim agency friction, as measured by the persistence of the private information is large, and she prefers an impatient agent if it is small. Finally, when global incentive constraints bind, we (i) provide the complete recursive solution, and (ii) characterize a simpler incentive compatible contract that is approximately optimal.

Keywords: Dynamic Mechanism Design, Financial Contracting, Unequal Discounting

JEL Classification: D82, D86

Suggested Citation

Krasikov, Ilia and Lamba, Rohit and Mettral, Thomas, Of Restarts and Shutdowns: Dynamic Contracts With Unequal Discounting (March 17, 2018). Available at SSRN: https://ssrn.com/abstract=3142932 or http://dx.doi.org/10.2139/ssrn.3142932

Ilia Krasikov

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

Rohit Lamba (Contact Author)

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

University Park, PA 16802-3306
United States

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

Thomas Mettral

Humboldt University of Berlin ( email )

Unter den Linden 6
Berlin, AK Berlin 10099
Germany

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