Munich Personal RePEc Archive

Dynamic Contracting with Persistent Shocks

Zhang, Yuzhe (2009): Dynamic Contracting with Persistent Shocks. Published in: Journal of Economic Theory , Vol. 144, No. 2 (March 2009): pp. 635-675.

[img]
Preview
PDF
MPRA_paper_23108.pdf

Download (398Kb) | Preview

Abstract

In this paper, we develop continuous-time methods for solving dynamic principal-agent problems in which the agent's privately observed productivity shocks are persistent over time. We characterize the optimal contract as the solution to a system of ordinary differential equations and show that, under this contract, the agent's utility converges to its lower bound|immiserization occurs. Unlike under risk-neutrality, the wedge between the marginal rate of transformation and a low-productivity agent's marginal rate of substitution between consumption and leisure will not vanish permanently at her first high-productivity report; also, the wedge increases with the duration of a low-productivity report. We apply the methods to numerically solve the Mirrleesian dynamic taxation model, and find that the wedge is significantly larger than that in the independently and identically distributed (i.i.d.) shock case.

UB_LMU-Logo
MPRA is a RePEc service hosted by
the Munich University Library in Germany.