Contracting with Repeated Moral Hazard and Private Evaluations

46 Pages Posted: 21 Nov 2005

See all articles by William Fuchs

William Fuchs

University of Texas at Austin - Department of Finance; Charles III University of Madrid - Department of Economics

Date Written: October 27, 2006

Abstract

A repeated moral hazard setting in which the Principal privately observes the Agent's output is studied. It is shown that there is no loss from restricting the analysis to contracts in which the Agent is supposed to exert effort every period, receives a constant efficiency wage and no feedback until he is fired. The optimal contract for a finite horizon is characterized, and shown to require burning of resources. These are only burnt after the worst possible realization sequence and the amount is independent of both the length of the horizon and the discount factor (delta). For the infinite horizon case a family of fixed interval review contracts is characterized and shown to achieve first best as delta approaches 1. The optimal contract when delta << 1 is partially characterized. Incentives are optimally provided with a combination of efficiency wages and the threat of termination, which will exhibit memory over the whole history of realizations. Finally, Tournaments are shown to provide an alternative solution to the problem.

Keywords: Moral Hazard, Private Monitoring, Efficiency Wages

JEL Classification: C7, D8, D4

Suggested Citation

Fuchs, William Martin, Contracting with Repeated Moral Hazard and Private Evaluations (October 27, 2006). Available at SSRN: https://ssrn.com/abstract=852344 or http://dx.doi.org/10.2139/ssrn.852344

William Martin Fuchs (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States

Charles III University of Madrid - Department of Economics ( email )

Calle Madrid 126
Getafe, 28903
Spain

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