TY - JOUR
T1 - Ambiguity in dynamic contracts
AU - Szydlowski, Martin
AU - Yoon, Ji Hee
N1 - Publisher Copyright:
© 2021 Elsevier Inc.
PY - 2021
Y1 - 2021
N2 - We study a continuous-time principal-agent model in which the principal is ambiguity averse about the agent's effort cost. The robust contract generates a seemingly excessive pay-performance sensitivity. The worst-case effort cost is high after good performance, but low after bad performance, which leads to overcompensation and undercompensation respectively and provides a new rationale for performance-sensitive debt. We also characterize the agent's incentives when the contract is misspecified, i.e., he is offered the robust contract, but his true effort cost differs from the worst case. Then, termination can induce shirking, the strength of incentives is hump-shaped, and agents close to firing prefer riskier projects, while those close to getting paid prefer safer ones. This feature resembles careers in organizations, most notably risk-shifting and the quiet life.
AB - We study a continuous-time principal-agent model in which the principal is ambiguity averse about the agent's effort cost. The robust contract generates a seemingly excessive pay-performance sensitivity. The worst-case effort cost is high after good performance, but low after bad performance, which leads to overcompensation and undercompensation respectively and provides a new rationale for performance-sensitive debt. We also characterize the agent's incentives when the contract is misspecified, i.e., he is offered the robust contract, but his true effort cost differs from the worst case. Then, termination can induce shirking, the strength of incentives is hump-shaped, and agents close to firing prefer riskier projects, while those close to getting paid prefer safer ones. This feature resembles careers in organizations, most notably risk-shifting and the quiet life.
KW - Ambiguity
KW - Continuous time
KW - Overcompensation
KW - Principal-agent model
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U2 - 10.1016/j.jet.2021.105229
DO - 10.1016/j.jet.2021.105229
M3 - Article
AN - SCOPUS:85101676180
SN - 0022-0531
VL - 199
JO - Journal of Economic Theory
JF - Journal of Economic Theory
M1 - 105229
ER -