Dynamic Moral Hazard and Stopping
Paper number: 13/14
Paper date: 3 January 2011
Paper Category: Discussion Paper
Robin Mason and Juuso Välimäki
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. 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. The long-run levels of the value and wage depend on the relative discount rates of the principal and agent. We also characterise the set of sequentially rational equilibria, where the principal has no commitment power.
Keywords: Principal-agent model, continuous time, moral hazard, project completion.
JEL classification: C73; D82; J31.