Optimal Compensation with Adverse Selection and Dynamic Actions

39 Pages Posted: 21 Mar 2006

See all articles by Jaksa Cvitanic

Jaksa Cvitanic

California Institute of Technology - Division of the Humanities and Social Sciences

Jianfeng Zhang

University of Southern California - Department of Mathematics

Date Written: December 13, 2006

Abstract

We consider continuous-time models in which the agent is paid at the end of the time horizon by the principal, who does not know the agent's type. The agent dynamically affects either the drift of the underlying output process, or its volatility. The principal's problem reduces to a calculus of variation problem for the agent's level of utility. The optimal ratio of marginal utilities is random, via dependence on the underlying output process. When the agent affects the drift only, in the risk-neutral case lower volatility corresponds to the more incentive optimal contract for the smaller range of agents who get rent above the reservation utility. If only the volatility is affected, the optimal contract is necessarily non-incentive, unlike in the first-best case. We also suggest a procedure for finding simple and reasonable contracts, which, however, are not necessarily optimal.

Keywords: Adverse selection, moral hazard, principal-agent problems, contracts, continuous-time models

JEL Classification: C61, J33

Suggested Citation

Cvitanic, Jaksa and Zhang, Jianfeng, Optimal Compensation with Adverse Selection and Dynamic Actions (December 13, 2006). Available at SSRN: https://ssrn.com/abstract=892486 or http://dx.doi.org/10.2139/ssrn.892486

Jaksa Cvitanic (Contact Author)

California Institute of Technology - Division of the Humanities and Social Sciences ( email )

1200 East California Blvd.
Pasadena, CA 91125
United States

HOME PAGE: http://www.hss.caltech.edu/~cvitanic/

Jianfeng Zhang

University of Southern California - Department of Mathematics ( email )

Los Angeles, CA 90089
United States

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