Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring

56 Pages Posted: 14 Sep 2016

See all articles by Tomasz Piskorski

Tomasz Piskorski

Columbia Business School - Finance and Economics

Mark M. Westerfield

University of Washington

Multiple version iconThere are 2 versions of this paper

Date Written: July 2016

Abstract

We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. We present a novel characterization of optimal dynamic incentive provision when performance-based incentives may decline continuously to zero. Termination happens in equilibrium only if its costs are relatively low. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Keywords: Monitoring, Dynamic Contracts, Managerial Compensation, Moral Hazard, Endogenous Financing Constraints

JEL Classification: D82, D86, M52

Suggested Citation

Piskorski, Tomasz and Westerfield, Mark M., Optimal Dynamic Contracts with Moral Hazard and Costly Monitoring (July 2016). Journal of Economic Theory, Forthcoming, Columbia Business School Research Paper No. 16-66, Available at SSRN: https://ssrn.com/abstract=2838519

Tomasz Piskorski

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Mark M. Westerfield (Contact Author)

University of Washington ( email )

Box 353200
Seattle, WA 98195
United States

HOME PAGE: http://www.markwesterfield.com

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