Dynamic Mechanism Design with Hidden Income and Hidden Auctions

66 Pages Posted: 28 Jul 2004

See all articles by Matthias Doepke

Matthias Doepke

Northwestern University - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); IZA Institute of Labor Economics

Robert M. Townsend

MIT - Department of Economics

Date Written: June 2004

Abstract

We develop general recursive methods to solve for optimal contracts in dynamic principal-agent environments with hidden states and hidden actions. In our baseline model, the principal observes nothing other than transfers. Nevertheless, optimal incentive-constrained insurance can be attained. We show that the optimal contract can be implemented as a recursive direct mechanism with a vector of utility promises as the state variable. The standard recursive formulation suffers from a curse of dimensionality that arises from the interaction of hidden income and hidden actions; this curse can be overcome by introducing judiciously chosen utility bounds for deviation behavior off the equilibrium path. Our methods generalize to environments with multiple actions and additional states. The key to implementing these extensions is to introduce multiple layers of off-path utility bounds.

Keywords: Mechanism design, dynamic contracts, recursive contracts

JEL Classification: C73, D82

Suggested Citation

Doepke, Matthias and Townsend, Robert M., Dynamic Mechanism Design with Hidden Income and Hidden Auctions (June 2004). CEPR Discussion Paper No. 4455. Available at SSRN: https://ssrn.com/abstract=570205

Matthias Doepke (Contact Author)

Northwestern University - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

London
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National Bureau of Economic Research (NBER)

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IZA Institute of Labor Economics

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Robert M. Townsend

MIT - Department of Economics ( email )

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Cambridge, MA 02142
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617-253-1330 (Fax)

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