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Disagreement and Learning in a Dynamic Contracting Model

Author

Listed:
  • Mark Westerfield

    (University of Southern California)

  • Tobias Adrian

    (Federal Reserve Bank of New York)

Abstract

We present a dynamic contracting model in which the principal and agent disagree about the resolution of uncertainty, and we illustrate the contract design in an application with Bayesian learning. The disagreement creates gains from trade that the principal realizes by transferring payment to states that the agent considers relatively more likely, changing incentives. The interaction between incentive provision and learning creates an intertemporal source of "disagreement risk" that changes second-best risk sharing. There is a regime shift between economies with small and large belief differences, and an early shock to beliefs can lead to large persistent differences in variable pay even after beliefs have converged. The principal's value function is convex in the underlying belief differences because the more optimistic the agent relative to the principal, the sharper the incentives and the lower the agent's required compensation; the result is a value to uncertainty and learning. Under risk- neutrality, "selling the firm" to the agent does not implement the first best because it precludes state-contingent trades.

Suggested Citation

  • Mark Westerfield & Tobias Adrian, 2007. "Disagreement and Learning in a Dynamic Contracting Model," 2007 Meeting Papers 270, Society for Economic Dynamics.
  • Handle: RePEc:red:sed007:270
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    References listed on IDEAS

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    Cited by:

    1. Giat, Yahel & Subramanian, Ajay, 2013. "Dynamic contracting under imperfect public information and asymmetric beliefs," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2833-2861.
    2. Thibaut Mastrolia & Dylan Possamaï, 2018. "Moral Hazard Under Ambiguity," Journal of Optimization Theory and Applications, Springer, vol. 179(2), pages 452-500, November.
    3. Zhiguo He & Bin Wei & Jianfeng Yu & Feng Gao, 2017. "Optimal Long-Term Contracting with Learning," The Review of Financial Studies, Society for Financial Studies, vol. 30(6), pages 2006-2065.
    4. , & ,, 2014. "Dynamic contracts when agent's quality is unknown," Theoretical Economics, Econometric Society, vol. 9(3), September.
    5. Leonidas Enrique De La Rosa, 2008. "Overconfidence in a Career-Concerns Setting," CESifo Working Paper Series 2405, CESifo.
    6. Duane Windsor, 2010. "The Role of Dynamics in Stakeholder Thinking," Journal of Business Ethics, Springer, vol. 96(1), pages 79-87, August.
    7. Bhattacharjee, Swagata, 2022. "Dynamic contracting for innovation under ambiguity," Games and Economic Behavior, Elsevier, vol. 132(C), pages 534-552.
    8. Marie-Louise Vierø, 2012. "Contracting in Vague Environments," American Economic Journal: Microeconomics, American Economic Association, vol. 4(2), pages 104-130, May.
    9. Thibaut Mastrolia & Dylan Possamai, 2015. "Moral hazard under ambiguity," Papers 1511.03616, arXiv.org, revised Oct 2016.
    10. Hansen, Peter G., 2022. "New formulations of ambiguous volatility with an application to optimal dynamic contracting," Journal of Economic Theory, Elsevier, vol. 199(C).
    11. Kondor, Peter & Koszegi, Botond, 2017. "Financial choice and financial information," LSE Research Online Documents on Economics 118973, London School of Economics and Political Science, LSE Library.
    12. Rajiv Sethi & Muhamet Yildiz, 2012. "Public Disagreement," American Economic Journal: Microeconomics, American Economic Association, vol. 4(3), pages 57-95, August.
    13. Hae Won (Henny) Jung & Ajay Subramanian, 2014. "Capital Structure under Heterogeneous Beliefs," Review of Finance, European Finance Association, vol. 18(5), pages 1617-1681.
    14. Botond Koszegi & Peter Kondor, 2015. "Cursed financial innovation," 2015 Meeting Papers 1098, Society for Economic Dynamics.
    15. Peter G. Hansen, 2021. "New Formulations of Ambiguous Volatility with an Application to Optimal Dynamic Contracting," Papers 2101.12306, arXiv.org.
    16. Swagata Bhattacharjee, 2019. "Dynamic Contracting for Innovation Under Ambiguity," Working Papers 1022, Ashoka University, Department of Economics, revised Aug 2019.
    17. de la Rosa, Leonidas Enrique, 2011. "Overconfidence and moral hazard," Games and Economic Behavior, Elsevier, vol. 73(2), pages 429-451.
    18. Anja Sautmann, 2011. "Contracts for Agents with Biased Beliefs: Some Theory and an Experiment," Working Papers 2011-10, Brown University, Department of Economics.
    19. Dylan Possamai & Nizar Touzi, 2020. "Is there a Golden Parachute in Sannikov's principal-agent problem?," Papers 2007.05529, arXiv.org, revised Oct 2022.
    20. Shi Chen & Jyh-Horng Lin & Wenyu Yao & Fu-Wei Huang, 2019. "CEO Overconfidence and Shadow-Banking Life Insurer Performance Under Government Purchases of Distressed Assets," Risks, MDPI, vol. 7(1), pages 1-25, March.

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    More about this item

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D0 - Microeconomics - - General
    • G0 - Financial Economics - - General

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