Dynamic Moral Hazard Without Commitment

49 Pages Posted: 19 Feb 2015

See all articles by Johannes Horner

Johannes Horner

Yale University - Cowles Foundation

Larry Samuelson

Yale University - Department of Economics; Yale University - Cowles Foundation

Date Written: February 18, 2015

Abstract

We study a discrete-time model of repeated moral hazard without commitment. In every period, a principal finances a project, choosing the scale of the project and a contingent payment plan for an agent, who has the opportunity to appropriate the returns of a successful project unbeknownst the principal. The absence of commitment is reflected both in the solution concept (perfect Bayesian equilibrium) and in the ability of the principal to freely revise the project's scale from one period to the next. We show that removing commitment from the equilibrium concept is relatively innocuous -- if the players are sufficiently patient, there are equilibria with payoffs low enough to effectively endow the players with the requisite commitment, within the confines of perfect Bayesian equilibrium. In contrast, the frictionless choice of scale has a significant effect on the project's dynamics. Starting from the principal's favorite equilibrium, the optimal contract eventually converges to the repetition of the stage-game Nash equilibrium, operating the project at maximum scale and compensating the agent (only) via immediate payments.

Keywords: Moral hazard, Dynamic moral hazard, Commitment, Principal-agent, Cash flow diversion

JEL Classification: C72, D82, D86

Suggested Citation

Horner, Johannes and Samuelson, Larry, Dynamic Moral Hazard Without Commitment (February 18, 2015). Cowles Foundation Discussion Paper No. 1989, Available at SSRN: https://ssrn.com/abstract=2566784 or http://dx.doi.org/10.2139/ssrn.2566784

Johannes Horner

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States

Larry Samuelson (Contact Author)

Yale University - Department of Economics ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

Yale University - Cowles Foundation

Box 208281
New Haven, CT 06520-8281
United States

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