Implications of Unequal Discounting in Dynamic Contracting
38 Pages Posted: 19 Mar 2018 Last revised: 24 Sep 2019
Date Written: September 22, 2019
This paper studies a canonical dynamic screening model where the principal’s discount factor is larger than the agent, the agent has limited commitment and payoff relevant private information that follows a Markov process. The interaction of unequal discounting and limited commitment with persistent agency frictions produces a novel tradeoff: (i) new intertemporal costs of incentive provision emerge, and (ii) the net present value of the standard information rent decreases. The former ensure that the shadow price of incentive constraints are permanently positive, and the latter contributes towards decreasing distortions since principal and agent evaluate future payoffs differently.
The optimal contract mostly exhibits a rather simple cyclical form that we term restart: (i) distortions decrease monotonically in the consecutive number of low shocks; (ii) a high shock erases all previous history of distortions, and then (iii) for every consecutive low shock, distortions follow the same path as before. Invoking an automaton inspired definition, restart contracts are shown to be simple. The optimal restart contract is (globally) optimal when the relaxed approach works, and approximately optimal otherwise.
The setup admits a host of applications where one party is "financially bigger" and the other is armed with some private information. Examples include a venture capitalist-entrepreneur relationship, loan contracts between the International Monetary Fund and emerging markets, and governments redistributing amongst heterogeneous citizens.
Keywords: Dynamic Mechanism Design, Financial Contracting, Unequal Discounting
JEL Classification: D82, D86
Suggested Citation: Suggested Citation