Abstract
We study the optimal dynamics of incentives for a manager whose ability to generate cash flows changes stochastically with time and is his private information. We show that distortions (aka, wedges) under optimal contracts may either increase or decrease over time. In particular, when the manager's risk aversion and ability persistence are small, distortions decrease, on average, over time. For sufficiently high degrees of risk aversion and ability persistence, instead, distortions increase, on average, with tenure. Our results follow from a novel variational approach that permits us to tackle directly the "full program," thus bypassing some of the difficulties of the "first-order approach" encountered in the dynamic mechanism design literature.
Keywords
managerial compensation; incentives; pay for performance; dynamic mechanism design; adverse selection; moral hazard; persistent productivity shocks; risk aversion; wedges; variational approach; first-order approach;
Reference
Daniel F. Garrett, and Alessandro Pavan, “Dynamic Managerial Compensation: A Variational Approach”, Journal of Economic Theory, vol. 159, September 2015, pp. 775–818.
See also
Published in
Journal of Economic Theory, vol. 159, September 2015, pp. 775–818