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Optimal dynamic contracts with moral hazard and costly monitoring

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  • Piskorski, Tomasz
  • Westerfield, Mark M.

Abstract

We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. We present a novel characterization of optimal dynamic incentive provision when performance-based incentives may decline continuously to zero. Termination happens in equilibrium only if its costs are relatively low. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Suggested Citation

  • Piskorski, Tomasz & Westerfield, Mark M., 2016. "Optimal dynamic contracts with moral hazard and costly monitoring," Journal of Economic Theory, Elsevier, vol. 166(C), pages 242-281.
    • Handle: RePEc:eee:jetheo:v:166:y:2016:i:c:p:242-281
    DOI: 10.1016/j.jet.2016.08.003
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    Cited by:

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    3. Nirav Mehta, 2019. "Measuring quality for use in incentive schemes: The case of “shrinkage” estimators," Quantitative Economics, Econometric Society, vol. 10(4), pages 1537-1577, November.
    4. Tak-Yuen Wong, 2019. "Dynamic Agency and Endogenous Risk-Taking," Management Science, INFORMS, vol. 65(9), pages 4032-4048, September.
    5. Pierre Chaigneau & Nicolas Sahuguet, 2023. "The Complementarity Between Signal Informativeness and Monitoring," Journal of Accounting Research, Wiley Blackwell, vol. 61(1), pages 141-185, March.
    6. Felix Zhiyu Feng & Wenyu Wang & Yufeng Wu & Gaoqing Zhang, 2023. "Ignorance Is Bliss: The Screening Effect of (Noisy) Information," Papers 2302.11128, arXiv.org, revised Aug 2024.
    7. Mayer, Simon, 2022. "Financing breakthroughs under failure risk," Journal of Financial Economics, Elsevier, vol. 144(3), pages 807-848.
    8. Orlov, Dmitry, 2022. "Frequent monitoring in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 206(C).
    9. Zhiyao Chen & Ilya A. Strebulaev & Yuhang Xing & Xiaoyan Zhang, 2021. "Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle: An Empirical Investigation," Management Science, INFORMS, vol. 67(5), pages 2751-2772, May.
    10. Zhiyao Chen & Ran Duchin, 2024. "Do Nonfinancial Firms Use Financial Assets to Take Risk?," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 13(1), pages 1-37.
    11. Xun Liu & Sen Lin & Lixing Liu & Fei Qian & Kun Zhang, 2020. "Exploring the Factors Triggering Occupational Ethics Risk of Technology Transaction in Chinese Construction Industry," IJERPH, MDPI, vol. 17(4), pages 1-18, February.
    12. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    13. Graham, John R. & Kim, Hyunseob & Leary, Mark, 2020. "CEO-board dynamics," Journal of Financial Economics, Elsevier, vol. 137(3), pages 612-636.
    14. Grochulski, Borys & Zhang, Yuzhe, 2023. "Termination as an incentive device," Theoretical Economics, Econometric Society, vol. 18(1), January.
    15. Feng, Felix Zhiyu & Westerfield, Mark M., 2021. "Dynamic resource allocation with hidden volatility," Journal of Financial Economics, Elsevier, vol. 140(2), pages 560-581.
    16. Shibata, Takashi & Nishihara, Michi, 2023. "Optimal financing and investment strategies under asymmetric information on liquidation value," Journal of Banking & Finance, Elsevier, vol. 146(C).
    17. Barbos, Andrei, 2019. "Dynamic contracts with random monitoring," Journal of Mathematical Economics, Elsevier, vol. 85(C), pages 1-16.
    18. Hori, Keiichi & Osano, Hiroshi, 2020. "Dynamic contract and discretionary termination policy under loss aversion," Journal of Economic Dynamics and Control, Elsevier, vol. 111(C).
    19. Aaron Finkle & Dongsoo Shin, 2020. "Obstructive monitoring," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 29(4), pages 873-891, October.
    20. Achim, Peter & Knoepfle, Jan, 2024. "Relational enforcement," Theoretical Economics, Econometric Society, vol. 19(2), May.
    21. Dylan Possamai & Nizar Touzi, 2020. "Is there a Golden Parachute in Sannikov's principal-agent problem?," Papers 2007.05529, arXiv.org, revised Oct 2022.
    22. Shiming Fu & Giulio Trigilia, 2018. "Voluntary disclosure under dynamic moral hazard," 2018 Meeting Papers 448, Society for Economic Dynamics.
    23. Rodivilov, Alexander, 2022. "Monitoring innovation," Games and Economic Behavior, Elsevier, vol. 135(C), pages 297-326.

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    More about this item

    Keywords

    Monitoring; Dynamic contracts; Managerial compensation; Moral hazard; Endogenous financing constraints;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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