DP11431 The curse of long horizons

Author(s): Venkataraman Bhaskar, George J Mailath
Publication Date: August 2016
Keyword(s): differences in beliefs, high-powered incentives., moral hazard, principal-agency
JEL(s): D01, D23, D86, J30
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11431

We study dynamic moral hazard with symmetric ex ante uncertainty about the difficulty of the job. The principal and agent update their beliefs about the difficulty as they observe output. Effort is private and the principal can only offer spot contracts. The agent has an additional incentive to shirk beyond the disutility of effort when the principal induces effort: shirking results in the principal having incorrect beliefs. We show that the effort inducing contract must provide increasingly high powered incentives as the length of the relationship increases. Thus it is never optimal to always induce effort in very long relationships.