DP4455 Dynamic Mechanism Design with Hidden Income and Hidden Auctions

Author(s): Matthias Doepke , Robert M Townsend

Publication Date: June 2004

Keyword(s): mechanism design , dynamic contracts , recursive contracts

JEL(s): C73 , D82

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP4455.asp

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 behaviour 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.