The Curse of Long Horizons

Abstract

We study dynamic moral hazard when the principal can only commit to spot contracts. Principal and agent are ex ante symmetrically uncertain about the difficulty of the job, and update their beliefs on observing output. Since the agent’s effort is private, he has an additional incentive to shirk when the principal induces effort: shirking results in the principal having incorrect beliefs, giving rise to future informational rents. We show that the effort inducing contract must provide increasingly high powered incentives as the length of the relationship increases. Thus it is never optimal to always induce effort in very long relationships.

Keywords: principal-agency, moral hazard, differences in beliefs, high-powered incentives

JEL Classification: D01, D23, D86, J30