DP6857 Dynamic Moral Hazard and Project Completion

Author(s): Robin Mason , Juuso Välimäki

Publication Date: June 2008

Keyword(s): continuous time , moral hazard , Principal-agent model , project completion

JEL(s): C73 , D82 , J31

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP6857.asp.asp

We analyse a simple model of dynamic moral hazard in which there is a clear and tractable trade-off; between static and dynamic incentives. In our model, a principal wants an agent to complete a project. The agent undertakes unobservable effort, which affects in each period the probability that the project is completed. The principal pays only on completion of the project. We characterise the contracts that the principal sets, with and without commitment. We show that with full commitment, the contract involves the agent’s value and wage declining over time, in order to give the agent incentives to exert effort.