DP7578 Tractability in Incentive Contracting

Author(s): Alex Edmans , Xavier Gabaix

Publication Date: November 2009

Keyword(s): closed forms , contract theory , dispersive order , executive compensation , incentives , principal-agent problem , subderivative

JEL(s): D2 , D3 , G34 , J3

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP7578.asp

This paper identifies a class of multiperiod agency problems in which the optimal contract is tractable (attainable in closed form). By modeling the noise before the action in each period, we force the contract to provide sufficient incentives state-by-state, rather than merely on average. This tightly constrains the set of admissible contracts and allows for a simple solution to the contracting problem. Our results continue to hold in continuous time, where noise and actions are simultaneous. We thus extend the tractable contracts of Holmstrom and Milgrom (1987) to settings that do not require exponential utility, a pecuniary cost of effort, Gaussian noise or continuous time. The contract's functional form is independent of the noise distribution. Moreover, if the cost of effort is pecuniary (multiplicative), the contract is linear (log-linear) in output and its slope is independent of the noise distribution, utility function and reservation utility. In a two-stage contracting game, the optimal target action depends on the costs and benefits of the environment, but is independent of the noise realization.