Moral Hazard with Persistent Actions and Learning

Nolan Miller

Abstract:  In a two-period principal-agent model, the distribution of outcomes in each period is affected by the agent's (single) effort choice as well as his type, which neither the principal nor the agent knows.  In this environment, the optimal long-term contract may involve overinsurance in the last period, giving the agent more utility following a loss than following no loss, even when the initial distribution satisfies the Monotone Likelihood Ratio Condition. Further, the optimal bilateral-commitment contract involves ex post inefficient payments in the second period that cannot be supported by short-term contracts. Because of this and the fact that bilateral commitment to long-term contracts allows the optimal contract to better allocate the agent's incentives over time, the bilateral-commitment contract Pareto dominates contracts where the parties are unable to commit.

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