Essays in relational contract theory

Abstract

This dissertation consists of 3 essays. The first essay studies a dynamic principal-agent problem where the agent's outside option is endogenously determined by the stock of effort. The compensation comes from 2 channels: the principal's explicit wage payment and the implicit outside option growth. On the one hand, the agent gains inherent work incentives under an increasing outside option. On the other hand, outside option growth makes the agent's participation constraint more stringent. I show that an agent is paid for his work in short-term contracts and for staying on the position in long-term contracts, rather than for work per se. The principal won't allow for infinite periods of work since it's costly to maintain an agent with outside options sufficiently high. The optimal contract is consistent with some academic empirical evidence on economics professors in the States. The second essay contributes to the understanding of the fast-track effect, the phenomenon that one is likely to be promoted faster in the future, given that he is promoted faster previously. The model is based on the assumption that both the principal and the agent are risk-neutral. It is found that the date of the first success has impacts throughout the entire career as well as the duration of the relationship. The ones who achieve their first success at an earlier date would experience faster growth on outside options throughout the entire career. Therefore, the selection of fast-tracks is not based on individual differences but the stochastic output realizations. In addition, career advancement also differs in the rate of outside option growth. Academic empirical evidence with a sample of top economists is found to support the fast-track results. In the third essay, I vary the risk-neutral assumption and look at the contract with a risk-averse agent. With a risk-averse agent, the fast-track effect no longer exists. In this case, higher performance pay not only induces incentives but also imposes higher risk which in turn generates a risk premium to be paid by the principal. Given that the agent has already delivered some high output, realizing high output would cost a higher risk premium and lead to less effort to be implemented in the next period.