Tractability in Incentive Contracting

69 Pages Posted: 11 Jan 2010

See all articles by Alex Edmans

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 3 versions of this paper

Date Written: November 2009

Abstract

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.

Keywords: closed forms, contract theory, dispersive order, executive compensation, incentives, principal-agent problem, subderivative

JEL Classification: D2, D3, G34, J3

Suggested Citation

Edmans, Alex and Gabaix, Xavier, Tractability in Incentive Contracting (November 2009). CEPR Discussion Paper No. DP7578, Available at SSRN: https://ssrn.com/abstract=1533183

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

London
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Xavier Gabaix

Harvard University - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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