On Dynamic Principal-Agent Problems in Continuous Time

Abstract

I study the provision of incentives in dynamic moral hazard models with hidden actions and possibly hidden states. I characterize implementable contracts by establishing the applicability of the first-order approach to contracting. Implementable contracts are history dependent, but can be written recursively with a small number of state variables. When the agent’s actions are hidden, but all states are observed, implementable contracts must take account of the agent’s utility process. When the agent has access to states which the principal cannot observe, implementable contracts must also take account of the shadow value (in marginal utility terms) of the hidden states. As an application of my results, I explicitly solve a model with linear production and exponential utility, showing how allocations are distorted for incentive reasons, and how access to hidden savings further alters allocations.