DP11766 A Theory of Threshold Contracts

Author(s): Johannes Gerd Becker, Hans Gersbach
Publication Date: January 2017
Keyword(s): asymmetric information, commitment, principal-agent model, reappointment, repeated game, stationary Markovian strategies, threshold contracts, threshold strategies
JEL(s): C83, D82, D86, H11
Programme Areas: Public Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11766

We consider an infinitely repeated reappointment game in a principal-agent relationship and examine the consequences of threshold contracts, which forbid reappointment if the principal's utility is too low. Typical examples are voter-politician or government-public servant relationships. The agent chooses costly effort and enjoys being in office until he is deselected. The principal observes a noisy signal of the agent's effort and decides whether to reappoint the agent or not. We analyse the stationary Markovian equilibria of this game with and without threshold contracts. We identify the circumstances under which such threshold contracts are welfare-improving or beneficial for the principal, which, in turn, may justify attempts to introduce such contracts in politics.