Renegotiation and Dynamic Inconsistency: Contracting with Non-Exponential Discounting

This paper studies a continuous-time, finite-horizon contracting problem with renegotiation and dynamic inconsistency arising from non-exponential discounting. The problem is formulated as a dynamic game played among the agent, the principal and their respective future "selves", each with their own discount function. We identify the principal optimal renegotiation-proof contract as a Markov perfect equilibrium (MPE) of the game, prove that such an MPE exists, and characterize the optimal contract via an extended Hamilton-Jacobi-Bellman system. We solve the optimal contract in closed-form when discounting is a function of the time-difference only and demonstrate the applicability of the results in several different settings.

Keywords: continuous-time contracting, dynamic inconsistency, renegotiation, extended HJB system, non-atomic games

JEL Classification: D82, D86, D91

Suggested Citation: Suggested Citation

Cetemen, Doruk and Feng, Felix and Urgun, Can, Renegotiation and Dynamic Inconsistency: Contracting with Non-Exponential Discounting (September 1, 2022). Journal of Economic Theory, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3442367 or http://dx.doi.org/10.2139/ssrn.3442367