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Ambiguity in dynamic contracts

Szydlowski, M; Yoon, JH; (2021) Ambiguity in dynamic contracts. Journal of Economic Theory , Article 105229. 10.1016/j.jet.2021.105229. (In press). Green open access

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Abstract

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.

Type: Article
Title: Ambiguity in dynamic contracts
Open access status: An open access version is available from UCL Discovery
DOI: 10.1016/j.jet.2021.105229
Publisher version: https://dx.doi.org/10.1016/j.jet.2021.105229
Language: English
Additional information: This version is the author accepted manuscript. For information on re-use, please refer to the publisher’s terms and conditions.
Keywords: Principal-agent model; Ambiguity; Continuous time; Overcompensation
UCL classification: UCL
UCL > Provost and Vice Provost Offices > UCL SLASH
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS > Dept of Economics
URI: https://discovery.ucl.ac.uk/id/eprint/10123830
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