Implications of Unequal Discounting in Dynamic Contracting
47 Pages Posted: 19 Mar 2018 Last revised: 12 Nov 2020
Date Written: November 12, 2020
A principal and agent sign on a dynamic contract where (i) the agent has Markovian private information that affects total surplus, (ii) the principal can commit to the contract and the agent has limited commitment, and (iii) the principal is more patient than the agent. The interaction of these three forces, which captures many applications in financial contracting, produces permanent distortions that go through cycles. The standard rent-versus-efficiency tradeoff that determines the optimal distortion is now enriched by two competing dynamic considerations: The principal backloads agent’s information rent as much as possible to relax incentive constraints, but unequal discounting introduces inter-temporal costs of incentive provision which front-load agent’s payoffs. The optimal contract pins down this tradeoff. Persistence of private information creates technical challenges in determining the set of binding incentive constraints– to deal with it, a notion of simplicity and approximate optimality is introduced.
Keywords: Dynamic Mechanism Design, Financial Contracting, Unequal Discounting
JEL Classification: D82, D86
Suggested Citation: Suggested Citation