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Punish Underperformance with Suspension: Optimal Dynamic Contracts in the Presence of Switching Cost

Author

Listed:
  • Ping Cao

    (International Institute of Finance, School of Management, University of Science and Technology of China, Hefei 230026, China)

  • Peng Sun

    (The Fuqua School of Business, Duke University, Durham, North Carolina 27708)

  • Feng Tian

    (Faculty of Business and Economics, University of Hong Kong, Hong Kong)

Abstract

This paper studies a dynamic principal–agent setting in which the principal needs to dynamically schedule an agent to work or be suspended. When the agent is directed to work and exert effort, the arrival rate of a Poisson process is increased, which increases the principal’s payoff. Suspension, on the other hand, serves as a threat to the agent by delaying future payments. A key feature of our setting is a switching cost whenever the suspension stops and the work starts again. We formulate the problem as an optimal control model with switching and fully characterize the optimal control policies/contract structures under different parameter settings. Our analysis shows that, when the switching cost is not too high, the optimal contract demonstrates a generalized control-band structure. The length of each suspension episode, on the other hand, is fixed. Overall, the optimal contract is easy to describe, compute, and implement.

Suggested Citation

  • Ping Cao & Peng Sun & Feng Tian, 2024. "Punish Underperformance with Suspension: Optimal Dynamic Contracts in the Presence of Switching Cost," Management Science, INFORMS, vol. 70(5), pages 3020-3037, May.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:5:p:3020-3037
    DOI: 10.1287/mnsc.2023.4845
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