Dynamic Incentive Contracts Under Parameter Uncertainty

49 Pages Posted: 30 Dec 2010 Last revised: 29 Oct 2014

See all articles by Julien Prat

Julien Prat

University of Vienna; IZA Institute of Labor Economics

Boyan Jovanovic

New York University - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: December 2010

Abstract

We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's 'quality', the Pareto frontier shifts inwards with better information. Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.

Suggested Citation

Prat, Julien and Jovanovic, Boyan, Dynamic Incentive Contracts Under Parameter Uncertainty (December 2010). NBER Working Paper No. w16649, Available at SSRN: https://ssrn.com/abstract=1732385

Julien Prat (Contact Author)

University of Vienna ( email )

Bruenner Strasse 72
Vienna 1210, Vienna
Austria

IZA Institute of Labor Economics

Schaumburg-Lippe-Str. 7 / 9
Bonn, D-53072
Germany

Boyan Jovanovic

New York University - Department of Economics ( email )

19 w 4 st.
New York, NY 10012
United States

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