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Optimal Contract in a Dynamic Agency Model with History-Dependent Participation Constraints

This paper considers a moral hazard problem in an innite-horizon, principal-agent framework characterized by limited commitment and history-dependent reservation utilities. I prove existence and construct a reduced equivalent representation of the problem that can be addressed by numerical techniques. In computing the endogenous state space, I use an innovative algorithm which does not rely on the convexity of the underlying set. I nd evidence that in the presence of positive correlation between stock prices and reservation utilities, the contract provides the agent with insurance against bad outcomes, which ultimately smoothes his/her consumption across (initial-history) states. Exerting e¤ort appears to be the predominant strategy for the principal, but shirking may still be optimal when the agent is rich enough. The optimal wage scheme and the future utility of the agent tend to grow in both his/her current utility and in the future realization of the stock price. Keywords: principal-agent problem, moral hazard, dynamic contracts, computational methods Journal of Economic Literature Classication Numbers: C63, D82, G30