Dynamic Principal-agent Model Research Articles

Optimal dynamic regulation with asymmetric information in continuous time: The case of electric power

<p>In this article, we analyze the mechanism design for the remuneration to the reduction of energy losses of a natural monopoly through a dynamic principal-agent model in continuous time. The objective of this research is to characterize the optimal regulation that induces reductions in electrical energy losses. In our methodology, we use a differential equation, its HJB representation, and an exponential utility function. The results suggest that the optimal contract is based on the agent's continuation value as a state variable. The article contributes to the analysis of control problems in conditions of incomplete information and incorporates information asymmetries and incentives in regulation. Among the future lines of research are the application of the model to specific energy markets and the empirical evaluation of the effectiveness of the proposed regulation.</p>

Risk-sharing and optimal contracts with large exogenous risks

We consider a dynamic principal–agent model that naturally extends the classical Holmström–Milgrom setting to include a risk capable of stopping production completely. 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 Holmström–Milgrom model and a linear prevention mechanism that is proportional to the random lifetime of the contract. We then extend the model by allowing insurable risks where the agent can control the intensity of the failure by exerting an additional costly effort.

Frequent monitoring in dynamic contracts

I consider a dynamic principal-agent model in which the agent does not observe the quality of his output and the principal chooses how much to monitor the agent. Monitoring improves production outcomes but can reduce the agent's incentive to work if it uncovers bad performance and leads to punishing the agent. The optimal monitoring intensity is path dependent: an agent who performed poorly in the past is monitored less going forward to reduce the risk of early termination. Conversely, an agent who performed well is monitored more as his accumulated promised compensation provides a buffer against bad monitoring outcomes and reduces the associated penalties by deferring the pay-for-performance risk to states of the world in which termination costs are low.

Financing breakthroughs under failure risk

In a dynamic principal-agent model, the principal, financing the project, cannot observe project failure and the agent, developing the project, can hide failure. As there is a tension between incentives for disclosure of failure and project development, the optimal contract does not reward failure and incentivize disclosure of failure during an initial unconditional financing stage. During the subsequent disclosure stage, time-decreasing rewards for failure provide incentives for disclosure of failure. The continuation of financing becomes more performance-sensitive across stages, and the agent’s incentives are backloaded. The model explains several empirical patterns in venture capital financing and the financing of innovation.

Prevent or Report? Managing Near Misses for Safer Operations

Problem Definition: Firms can reduce the risk of rare disasters by accounting for more frequent near misses: precursor events that could have escalated to a disaster but did not. Investigating a near miss reveals its root cause, allowing the firm to improve process safety and reduce disaster risk. A managing firm, however, usually does not directly observe the occurrence of a near miss but instead relies on the report of an agent (an employee or contractor) who is also responsible for precautionary measures that prevent such incidents. This paper explains why near-miss reporting may not take place in such a decentralized setting. Academic/practical relevance: Literature and practitioners have acknowledged the crucial role of near-miss reports in improving process safety. Nevertheless, even at sophisticated and experienced organizations, disaster inquiries invariably uncover a history of unreported or ignored near misses preceding an accident. We provide an explanation for this persistent phenomenon based on rational economic incentives. Methodology: We examine the firm’s problem through a dynamic principal-agent model that captures the agent’s potential for under-reporting near misses along with moral hazard related to their precautionary effort. Results: We find that the firm may fail to capitalize on near miss information because of conflicting incentives. For instance, the agent may be unwilling to report near misses because the resulting safety improvements hurt them financially. This happens because safety improvements replace the need for the agent’s precautionary effort, thereby lowering moral hazard and allowing the firm to extract more rent from the agent. However, even when the agent is willing to report near misses, we find that the firm may choose not to record them, opting instead to create stronger incentives for precaution. In both scenarios, the firm forgoes opportunities for process-safety improvement and instead focuses on existing precautionary measures. Managerial implications: Our findings highlight the challenges in providing incentives for both reporting and precautionary measures that can result in a failure to leverage near miss information. We examine remedies that alleviate these issues and increase reporting in both voluntary and mandatory reporting environments.

Self-respecting worker in the gig economy: A dynamic principal-agent model

We introduce a dynamic principal-agent model to understand the nature of contracts between an employer and an independent gig worker. We model the worker's self-respect with an endogenous backward-looking participation constraint; he accepts a job offer if and only if its utility is at least as large as his reference value, which is based on the average of previously realized wages. If the dynamically changing reference value capturing the worker's demand is too high, then no contract is struck until the reference value hits a threshold. Below the threshold, contracts are offered and accepted, and the worker's wage demand follows a stochastic process. We apply our model to perfectly competitive and monopsonistic labor market structures and investigate first-best and second-best solutions. We show that a far-sighted employer with market power may sacrifice instantaneous profit to regulate the agent's demand. Moreover, the far-sighted employer implements increasing and path-dependent effort levels. Our model captures the worker's bargaining power by a vulnerability parameter that measures the rate at which his wage demand decreases when unemployed. With a low vulnerability parameter, the worker can afford to go unemployed and need not take a job at all costs. Conversely, a worker with high vulnerability can be exploited by the employer, and in this case our model also exhibits self-exploitation.

Hidden Cost of Sanctions in a Dynamic Principal-Agent Model: Reactance to Controls and Restoration of Freedom

Hidden Cost of Sanctions in a Dynamic Principal-Agent Model: Reactance to Controls and Restoration of Freedom

Dynamic resource allocation with hidden volatility

We study a firm’s internal resource allocation using a dynamic principal-agent model with endogenous cash flow volatility. The principal supplies the agent with resources for productive use, but the agent has private control over both project volatility and resource intensity and may misallocate resources to obtain private benefits. The optimal contract can yield either overly risky or overly prudent project selection. It can be implemented with a constant pricing schedule (i.e., a static, decentralized, linear mechanism), giving the agent control over the resource quantities, project risk, and agent’s equity share. The implementation rationalizes the use of hurdle rates above a firm’s cost of capital and transfer prices above marginal cost, while showing that hurdle rates or transfer prices may not vary with the agent’s risk choice.

Discrete‐time dynamic principal–agent models: Contraction mapping theorem and computational treatment

We consider discrete‐time dynamic principal–agent problems with continuous choice sets and potentially multiple agents. We prove the existence of a unique solution for the principal's value function only assuming continuity of the functions and compactness of the choice sets. We do this by a contraction mapping theorem and so also obtain a convergence result for the value function iteration. To numerically compute a solution for the problem, we have to solve a collection of static principal–agent problems at each iteration. As a result, in the discrete‐time setting solving the static problem is the difficult step. If the agent's expected utility is a rational function of his action, then we can transform the bi‐level optimization problem into a standard nonlinear program. The final results of our solution method are numerical approximations of the policy and value functions for the dynamic principal–agent model. We illustrate our solution method by solving variations of two prominent social planning models from the economics literature.

Was Sarbanes-Oxley Costly? Evidence from Optimal Contracting on CEO Compensation

This paper investigates the effects of the Sarbanes-Oxley Act (SOX) on CEO compensation, using panel data constructed for the S&P 1500 firms on CEO compensation, financial returns, and reported accounting income. Empirically SOX (i) changes the relationship between a firm’s abnormal returns and CEO compensation, (ii) changes the underlying distribution of abnormal returns, and (iii) significantly raises the expected CEO compensation in the primary sector. We develop and estimate a dynamic principal agent model of hidden information and hidden actions to explain these regularities. We find that SOX (i) increased the administrative burden of compliance in the primary sector, but reduce this burden in the service sector, (ii) increased agency costs in most categories of the firms, and (iii) reduced the off-equilibrium loss from the CEO shirking.

Production priorities in dynamic relationships

We characterize optimal contracts in a dynamic principal–agent model of joint production in which project opportunities are heterogenous, utility from these projects is nontransferable, and the agent has the option to quit the relationship at any time. To demand the production of projects that benefit her but not the agent, the principal must commit to produce projects that benefit the agent in the future. Production at all stages of the relationship is ordered by projects' cost‐effectiveness, which is their efficiency in transferring utility between the principal and the agent: cost‐effective demands impose relatively low costs on the agent and cost‐effective compensation imposes relatively low costs on the principal. Over time, optimal contracts become more generous toward the agent by adding commitments to less cost‐effective compensation. In turn, because this new compensation cannot be profitably exchanged against less cost‐effective demands, the principal narrows the scope of her demands.

Optimal dynamic contracting: The first‐order approach and beyond

We explore the conditions under which the “first‐order approach” (FO approach) can be used to characterize profit maximizing contracts in dynamic principal–agent models. The FO approach works when the resulting FO‐optimal contract satisfies a particularly strong form of monotonicity in types, a condition that is satisfied in most of the solved examples studied in the literature. The main result of our paper is to show that except for nongeneric choices of the stochastic process governing the types' evolution, monotonicity and, more generally, incentive compatibility are necessarily violated by the FO‐optimal contract if the frequency of interactions is sufficiently high (or, equivalently, if the discount factor, time horizon, and persistence in types are sufficiently large). This suggests that the applicability of the FO approach is problematic in environments in which expected continuation values are important relative to per period payoffs. We also present conditions under which a class of incentive compatible contracts that can be easily characterized is approximately optimal.

Financing Breakthroughs under Failure Risk

In a dynamic principal-agent model, the principal, financing the project, cannot observe project failure and the agent, developing the project, can hide failure. As there is a tension between incentives for disclosure of failure and project development, the optimal contract does not reward failure and incentivize disclosure of failure during an initial unconditional financing stage. During the subsequent disclosure stage, time-decreasing rewards for failure provide incentives for disclosure of failure. The continuation of financing becomes more performance-sensitive across stages, and the agent's incentives are backloaded. The model explains several empirical patterns in venture capital financing and the financing of innovation.

Dynamic incentive remuneration design for functional recovery care

This paper considers the dynamic incentive remuneration design for functional recovery care by applying dynamic principal-agent model, where the long-term care provider is formulated as the agent and the long-term care insurer as the principal. The insurer designs a dynamic incentive remuneration strategy to encourage the provider to provide functional recovery care. In particular, the insurer pays the remuneration to the provider based on the health improvement of the insured person at the end of a contract period. In addition, since it is possible that the cost incurred by the provider is not recoverable if less or excessive functional recovery care effort is made, an optimal functional recovery care effort level will be recommended to the provider.

Dynamic incentive remuneration design for functional recovery care

This paper considers the dynamic incentive remuneration design for functional recovery care by applying dynamic principal-agent model, where the long-term care provider is formulated as the agent and the long-term care insurer as the principal. The insurer designs a dynamic incentive remuneration strategy to encourage the provider to provide functional recovery care. In particular, the insurer pays the remuneration to the provider based on the health improvement of the insured person at the end of a contract period. In addition, since it is possible that the cost incurred by the provider is not recoverable if less or excessive functional recovery care effort is made, an optimal functional recovery care effort level will be recommended to the provider.

Reporting (or Not) of Precursors to Disasters

Problem definition: Firms can reduce the risk of rare disasters by accounting for more frequent near misses: precursor events that could have escalated to a disaster but did not. Investigating a near miss reveals its root cause, allowing the firm to improve process safety and reduce disaster risk. A managing firm, however, usually does not directly observe the occurrence of a near miss, but instead relies on the report of a contractor who is also responsible for preventing such incidents by maintaining process safety. This paper explains why near miss reporting may not take place in such a decentralized setting. Academic/Practical Relevance:Literature and practitioners have acknowledged the crucial role of near miss reports in improving process safety. Nevertheless, even at sophisticated and experienced organizations, disaster inquiries invariably uncover a history of unreported or ignored near misses preceding an accident. We provide an explanation for this persistent phenomenon based on rational economic incentives. Methodology: We examine the firm's problem through a dynamic principal-agent model that captures the contractor's potential for under-reporting near misses along with \textit{moral hazard} related to preventive effort. Results: We find that the firm may fail to capitalize on near miss information due to conflicting incentives. This occurs, for instance, when the contractor is unwilling to report near misses because the resulting safety improvements replace the need for his unverifiable preventive effort, thereby lowering his compensation. However, even when the contractor is willing to report near misses, we find that the firm may choose not to record them, opting instead to create stronger incentives for prevention. In both scenarios, the firm forgoes opportunities for process-safety improvement, focusing on existing preventive measures. Managerial Implications: Our findings highlight the challenges in providing incentives for both reporting and prevention, that can result in a failure to leverage near miss information. We examine potential remedies to overcome these issues and increase reporting.

Deterministic versus stochastic contracts in a dynamic principal-agent model

I show that deterministic dynamic contracts between a principal and an agent are always at least as profitable to the principal as stochastic ones, if the so-called first-order approach in dynamic mechanism design is satisfied. The principal commits, while the agent's type evolution follows a Markov process. My results demonstrate, even when allowing for potential correlation of stochastic contracts across periods that the usual restriction in the literature to deterministic contracts is admissible, as long as the first-order approach is valid.

Enhancing Credibility and Commitment to Fiscal Rules

The objective of this paper is to derive the characteristics of an effective fiscal governance framework, focusing on the incentives that ensure a commitment to the fiscal rules. We study this problem with the use of econometric tools, complementing this analysis with formal modelling through the lens of a dynamic principal-agent framework. Our study shows that both economic and institutional factors play an important role in incentivising countries’ fiscal efforts. Fiscal balances are affected not only by the economic cycle, but, among others, by the level of public debt and the world economic situation. We find that the existence of numerical fiscal rules, their strong legal entrenchment, surveillance mechanisms, and credible sanctions binding the hands of governments have a significant impact on curbing deficits. The relationship between the Commission and European Union (EU) Member States (MS), where the EU authorities act as a collective principal that designs contracts for MS, has elements in common with the assumptions of the principal-agent framework. These are: asymmetry of information, moral hazard, different objectives, and the ability to reward or punish the principal. We use a dynamic principal-agent model and show that to ensure good fiscal performance, indirect benefits should be envisaged for higher levels of fiscal effort. In order to account for the structural differences of exerting effort by different MS, it is efficient to adjust fiscal effort to the level of indebtedness. To ensure a commitment to the rules, MS with difficulties conducting prudent fiscal policies should be required to exert less effort than the MS with more modest levels of debt.

A Solvable Dynamic Principal-Agent Model with Linear Marginal Productivity

We study how to design an optimal contract which provides incentives for agent to put forth the desired effort in a continuous time dynamic moral hazard model with linear marginal productivity. Using exponential utility and linear production, three different information structures, full information, hidden actions and hidden savings, are considered in the principal-agent model. Applying the stochastic maximum principle, we solve the model explicitly, where the agent’s optimization problem becomes the principal’s problem of choosing an optimal contract. The explicit solutions to our model allow us to analyze the distortion of allocations. The main effect of hidden actions is a reduction of effort, but the a smaller effect is on the consumption allocation. In the hidden saving case, the consumption distortion almost vanishes but the effort distortion is expanded. In our setting, the agent’s optimal effort is also reduced with the decline of marginal productivity.

Optimal incentive contracts with job destruction risk

We study the implications of job destruction risk for optimal incentives in a long-term contract with moral hazard. We extend the dynamic principal-agent model of Sannikov (2008) by adding an exogenous Poisson shock that makes the match between the firm and the agent permanently unproductive. In modeling job destruction as an exogenous Poisson shock, we follow the Diamond-Mortensen-Pissarides search-and-matching literature. The optimal contract shows how job destruction risk is shared between the rm and the agent. Arrival of the job-destruction shock is always bad news for the rm but can be good news for the agent. In particular, under weak conditions, the optimal contract has exactly two regions. If the agent's continuation value is below a threshold, the agent's continuation value experiences a negative jump upon arrival of the job-destruction shock. If the agent's value is above this threshold, however, the jump in the agent's continuation value is positive, i.e., the agent gets rewarded when the match becomes unproductive. This pattern of adjustment of the agent's value at job destruction allows the firm to reduce the costs of effort incentives while the match is productive. In particular, it allows the firm to adjust the drift of the agent's continuation value process so as to decrease the risk of reaching either of the two inefficient agent retirement points. Further, we study the sensitivity of the optimal contract to the arrival rate of job destruction.