Working paper

A Class of Explicit optimal contracts in the face of shutdown

Jessica Martin, and Stéphane Villeneuve

Abstract

What type of delegation contract should be offered when facing a risk of the magnitude of the pandemic we are currently experiencing and how does the likelihood of an exogenous early termination of the relationship modify the terms of a full-commitment contract? We study these questions by considering a dynamic principal-agent model that naturally extends the classical Holmström-Milgrom setting to include a risk of default whose origin is independent of the inherent agency problem. We obtain an explicit characterization of the optimal wage along with the optimal action provided by the agent. The optimal contract is linear by offering both a fixed share of the output which is similar to the standard shutdown-free Holmström-Milgrom model and a linear prevention mechanism that is proportional to the random lifetime of the contract. We then tweak the model to add a possibility for risk mitigation through investment and study its optimality.

Keywords

Principal-Agent problems, default risk, Hamilton-Jacobi Bellman equations;

Reference

Jessica Martin, and Stéphane Villeneuve, A Class of Explicit optimal contracts in the face of shutdown, TSE Working Paper, n. 21-1183, January 2021.

See also

Published in

TSE Working Paper, n. 21-1183, January 2021