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Learning, Termination, and Payout Policy in Dynamic Incentive Contracts

Author

Listed:
  • Peter M. Demarzo
  • Yuliy Sannikov
Abstract
We study a principal–agent setting in which both sides learn about future profitability from output, and the project can be abandoned/terminated if profitability is too low. With learning, shirking by the agent both reduces output and lowers the principal’s estimate of future profitability. The agent can exploit this belief discrepancy and earn information rents, reducing his incentives to exert effort. The optimal contract controls information rents to improve incentives by distorting the termination decision. Our results capture the transition from a young, financially constrained firm to a mature firm that pays dividends. For young firms, poor performance permanently raises the termination threshold, as doing so lowers information rents. Mature firms pay smoothed dividends and have a fixed termination threshold. Dividend smoothing occurs because earnings surprises are used to adjust financial slack in line with profitability. When profitability only reflects the agent’s private ability, a simple equity contract is optimal.

Suggested Citation

  • Peter M. Demarzo & Yuliy Sannikov, 2017. "Learning, Termination, and Payout Policy in Dynamic Incentive Contracts," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 84(1), pages 182-236.
    • Handle: RePEc:oup:restud:v:84:y:2017:i:1:p:182-236.
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    File URL: http://hdl.handle.net/10.1093/restud/rdw029
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    More about this item

    Keywords

    Real options; inside information; moral hazard; dynamic contracts; payout policy; information rents;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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