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We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's 'quality', the Pareto frontier shifts inwards with better information. Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.
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This paper shows that endogenous cycles can arise when contracts between firms and their customers are incomplete and when products are experience goods. Then firms invest in the quality of their output in order to establish a good reputation. Cycles arise because investment in reputation causes self-fulfilling changes in the discount factor. Cycles are more likely to occur when information diffuses slowly and consumers exhibit high risk aversion. A rise in idiosyncratic uncertainty is of two kinds that work in opposite ways: Noise in observing effort is contractionary as it generally is in agency models. But a rise in the variance of the distribution of abilities is expansionary. A calibrated version produces realistic fluctuations in terms of peak-to-trough movements in consumption and the spacing of time between recessions.
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Cyclical patterns in earnings can arise when contracts between firms and their workers are incomplete, and when workers cannot borrow or lend so as to smooth their consumption. Earnings cycles generate occasional large changes in earnings, consistent with some recent empirical findings. At the calibrated parameter values, financial constraints promote investment in reputation - an intangible capital form - in contrast to their documented inhibiting effect on investment in tangible capital.
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This paper shows that endogenous cycles can arise when contracts between firms and their customers are incomplete and when products are experience goods. Then firms invest in the quality of their output in order to establish a good reputation. Cycles arise because investment in reputation causes self-fulfilling changes in the discount factor. Cycles are more likely to occur when information diffuses slowly and consumers exhibit high risk aversion. A rise in idiosyncratic uncertainty is of two kinds that work in opposite ways: Noise in observing effort is contractionary as it generally is in agency models. But a rise in the variance of the distribution of abilities is expansionary. A calibrated version produces realistic fluctuations in terms of peak-to-trough movements in consumption and the spacing of time between recessions.
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We analyze a long-term contracting problem involving common uncertainty about a parameter capturing the productivity of the relationship, and featuring a hidden action for the agent. We develop an approach that works for any utility function when the parameter and noise are normally distributed and when the effort and noise affect output additively. We then analytically solve for the optimal contract when the agent has exponential utility. We find that the Pareto frontier shifts out as information about the agent's quality improves. In the standard spot-market setup, by contrast, when the parameter measures the agent's 'quality', the Pareto frontier shifts inwards with better information. Commitment is therefore more valuable when quality is known more precisely. Incentives then are easier to provide because the agent has less room to manipulate the beliefs of the principal. Moreover, in contrast to results under one-period commitment, wage volatility declines as experience accumulates.
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Cyclical patterns in earnings can arise when contracts between firms and their workers are incomplete, and when workers cannot borrow or lend so as to smooth their consumption. Effort cycles generate occasional large changes in earnings. These large changes are transitory, consistent with recent empirical findings.
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Cyclical patterns in earnings can arise when contracts between firms and their workers are incomplete, and when workers cannot borrow or lend so as to smooth their consumption. Earnings cycles generate occasional large changes in earnings, consistent with some recent empirical findings. At the calibrated parameter values, financial constraints promote investment in reputation - an intangible capital form - in contrast to their documented inhibiting effect on investment in tangible capital.
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