ABSTRACT
We address a dynamic contracting model where a principal hires an agent to run a project. The key new ingredient is that the principal or agent also dynamically controls the volatility of cumulative output. Increasing the volatility has three effects: (i) a positive drift effect due to an increase in the firm’s risk premium, (ii) a negative drift effect meant to capture inefficiencies arising from risk-shifting, and (iii) a mechanical mean-preserving spread effect. We show that contract efficiency maximizes if agents instead of principals control project risk. The higher the promised value, the more significant the former’s advantage. There is a contract efficiency difference between the exogenous no-savings selection and the endogenous one, and it would be positive or negative depending on principals’ decision rules.
Yang, Zhaojun and Zhang, Yuqian, Dynamic Incentive Contracts with Controllable Risk.
Leave a Reply