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Risk-sharing and optimal contracts with large exogenous risks

Author

Listed:
  • Jessica Martin

    (Université de Toulouse)

  • Stéphane Villeneuve

    (Université Toulouse 1 Capitole, (TSE-TSMR))

Abstract

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.

Suggested Citation

  • Jessica Martin & Stéphane Villeneuve, 2023. "Risk-sharing and optimal contracts with large exogenous risks," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 46(1), pages 1-43, June.
    • Handle: RePEc:spr:decfin:v:46:y:2023:i:1:d:10.1007_s10203-023-00386-1
    DOI: 10.1007/s10203-023-00386-1
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Principal–agent problems; Risk-sharing; Hamilton–Jacobi–Bellman equations;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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