WP 2010-13 Dynamic Contracting under Imperfect Public Information and Asymmetric Beliefs

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Published in 2013 in Journal of Economic Dynamics and Control, Volume 37, Issue 12.

ABSTRACT. We develop a dynamic principal–agent model to show how imperfect public information and asymmetric beliefs, asymmetric risk attitudes, complementary actions by both parties, and inter-temporal adverse selection arising from the agent’s unobservable actions interact to affect optimal dynamic contracts. Our continuous-time formulation of the model, which features both “hidden actions” and “hidden states,” leads to a simple characterization of optimal contracts in terms of the solution to a first-order nonlinear ordinary differential equation (ODE). We exploit the properties of the ODE to derive a number of novel implications for the effects of asymmetric beliefs, agency conflicts, twosided actions, and adverse selection on contractual dynamics. Our results highlight the key role played by asymmetric beliefs in reconciling a number of empirical findings: the “private equity” puzzle; the non-monotonic relation between firm value and incentives, and the ambiguous relation between risk and incentives. We also derive empirically testable implications that alter the intuition gleaned from previous literature that does not incorporate the effects of asymmetric beliefs. The presence of dynamic adverse selection could cause risk-sharing to improve or deteriorate over time depending on the level of agent optimism. Asymmetric beliefs, agency conflicts and adverse election cause permanent and transient components of risk to have differing effects on compensation and investment schedules.