Publication Date: February 2015
We study a discrete-time model of repeated moral hazard without commitment. In every period, a principal ﬁnances a project, choosing the scale of the project and a contingent payment plan for an agent, who has the opportunity to appropriate the returns of a successful project unbeknownst the principal. The absence of commitment is reflected both in the solution concept (perfect Bayesian equilibrium) and in the ability of the principal to freely revise the project’s scale from one period to the next. We show that removing commitment from the equilibrium concept is relatively innocuous — if the players are suﬀiciently patient, there are equilibria with payoﬀs low enough to eﬀectively endow the players with the requisite commitment, within the conﬁnes of perfect Bayesian equilibrium. In contrast, the frictionless choice of scale has a signiﬁcant eﬀect on the project’s dynamics. Starting from the principal’s favorite equilibrium, the optimal contract eventually converges to the repetition of the stage-game Nash equilibrium, operating the project at maximum scale and compensating the agent (only) via immediate payments.
Moral hazard, Dynamic moral hazard, Commitment, Principal-agent, Cash flow diversion
JEL Classification Codes: C72, D82, D86
See CFP: 1514